Derivatives original pen and ink and watercolour illustration by Rosie Brooks

In finance, a derivative is a financial contract that derives its value from an underlying asset, such as stocks, bonds, commodities, currencies, or interest rates. The value of a derivative is based on the price movements of the underlying asset, but the derivative itself does not represent ownership of the asset.

There are various types of derivatives, including options, futures, forwards, and swaps.

Options give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price and date in the future.

Futures and forwards are similar in that they both involve a contract to buy or sell an underlying asset at a predetermined price and date in the future, but futures are traded on an exchange and standardized, while forwards are customized contracts between two parties.

Swaps involve the exchange of cash flows between two parties, based on a predetermined set of terms. Common types of swaps include interest rate swaps and currency swaps.

Derivatives are often used for hedging, speculation, or arbitrage. Hedging involves using derivatives to reduce or eliminate risk by offsetting potential losses from an underlying asset. Speculation involves using derivatives to profit from price movements of an underlying asset, while arbitrage involves exploiting price differences between two or more markets.

Derivatives can be complex financial instruments and carry significant risks, including counterparty risk, market risk, and liquidity risk. As a result, they are typically used by sophisticated investors and require a high level of understanding and expertise.