What a derivative is

What makes a contract a derivative?

A derivative is a financial contract that derives its value from the performance of an underlying : an asset, a group of assets, a rate, an index or an event. It fixes terms today for an exchange of cash flows, or of assets, at a later date.

Compare it with the cash market , where an asset changes hands now at the current spot price . Buying units of an index fund is a cash-market trade, not a derivative.

Take a running example. A Swiss pension fund agrees today to sell 2,000 shares of a listed pharmaceutical company to a bank in three months at CHF 52 a share. A derivative does not pass the share’s return straight through. It transforms it: here, it locks in a price.

$$P_{\text{short}} = N\,(F - S_T)$$

Here $N$ is the contract size, $F$ the agreed price and $S_T$ the spot price at maturity. The buyer’s result is the negative of this.

What are the parts of every derivative?

Every contract can be read from a term sheet with the same few lines. The counterparty is each legal entity that signs the contract, and at least one is usually a dealer.

Derivative contractwhat a term sheet lists

• Underlying Memorize asset, rate, index or event the value depends on
• Counterparties Use it the two legal entities, usually one a dealer
• Contract size Use it quantity or notional the payoff is computed on
• Price or rate Use it the pre-agreed forward price, fixed rate or exercise price
• Maturity and settlement Use it the closing date; paid in cash or by physical delivery
• Contract type Memorize firm commitment or contingent claim

Feature	What it means	In our example
Underlying	what the value depends on	the pharmaceutical share
Counterparties	the two legal entities	pension fund (seller), bank (buyer)
contract size (notional)	quantity or amount the payoff is computed on	2,000 shares
Price or rate	the pre-agreed price, rate or exercise price	CHF 52 a share
Maturity and settlement	when it closes, and how it is paid	three months; physical or cash
Contract type	firm commitment or contingent claim	firm commitment (a forward)

The buyer of a derivative holds a long position : its value moves like owning the underlying. The seller holds a short position , with exposure like a short sale. The pension fund above is short.

Firm commitment or contingent claim?

Memorize

In a firm commitment both parties are obliged to settle on the agreed terms. Forwards, futures and swaps are firm commitments.

In a contingent claim one party, the option buyer, decides whether and when to settle. An option is the main example.

Is it a derivative, and which kind?a derivative's value depends on an underlying and it settles later

• By obligation Memorize
  • Firm commitment Memorize both sides must settle
    • Forwardone exchange at maturity, customized
    • Futuresone exchange, standardized and exchange-traded
    • Swapa series of periodic exchanges
  • Contingent claim Memorize one side chooses whether and when to settle
    • Optionthe buyer decides; the seller must perform if asked
• By location Memorize
  • Stand-alone Use it its own contract, such as a forward on a share
  • Embedded Memorize built into another security: callable, putable, convertible bonds
• Not a derivative Memorize buying shares, an exchange-traded fund (ETF) or an index fund: a cash-market trade

A derivative can be a stand-alone derivative , its own contract, or an embedded derivative , built into another security. A callable bond has the issuer’s option to repay early, a putable bond has the investor’s option to sell it back, and a convertible bond has the investor’s option to swap into shares.

Try the sort:

Instrument	Classification
Fixed-price electricity supply contract	firm commitment
Option to buy an index in six months	contingent claim
Callable bond	contains a contingent claim (embedded)
Interest rate swap	firm commitment
Purchase of an exchange-traded fund (ETF)	neither: a cash-market trade
Warrant issued by a company	contingent claim

Exam tip ”Fixed price” is not the test. Ask who can walk away: if nobody can, it is a firm commitment.

Why do people use derivatives?

Five reasons recur: to bet on a fall without borrowing shares, to diversify or reshape a portfolio, to offset a commercial exposure, to gain a large exposure for a small cash outlay, and to trade at lower cost and often with better liquidity than the underlying.

Hedging is using a derivative to offset or neutralize an existing or expected exposure. The derivative is then called the hedge. The pension fund’s forward hedges its shares against a price fall.

Go deeper Why a contract worth zero at the start can carry large exposure

A forward usually costs nothing to enter, because the agreed price is set so that the contract has no value at the start. Its value then moves with the underlying every day, so the exposure can be large even though no cash changed hands. The next modules separate the price of a contract from its value.

Go deeper The legal wrapper: the ISDA master agreement

Over-the-counter contracts normally sit under an International Swaps and Derivatives Association (ISDA) master agreement, which fixes the documentation and the credit terms both sides accept.

Go deeper Employee stock options and warrants

A company can write options on its own shares. Employee stock options and warrants are derivatives written by the issuer itself: when they are exercised, the company issues new shares at the fixed price.