- (1) Financial instruments whose value depends upon the values of underlying assets, interest rates, currency exchange rates, or indexes. Various authorities define derivative instruments in broad, inclusive terms or narrow, exclusive terms. It is a common misconception that all derivatives are high-risk, speculative instruments. Large financial institutions use derivatives for hedging. Options, futures, swaps, and swaptions are common derivatives used for hedging purposes. All CMOs are derivatives. There are many derivative instruments, and new ones are developed often.See underlying.(2) In FAS 133, FASB defines derivatives narrowly. With some exceptions, FAS 133 defines a derivative instrument to be any financial instrument or other contract that has all three of the following characteristics:A. The financial instrument or contract has both:1. One or more underlyings.2. One or more notional amounts or payment provisions or both.B. The financial instrument or contract either does not require an initial investment or requires an initial net investment that is "smaller than the amount that would be required for other types of contracts that would be expected to have a similar response to changes in market factors."C. The terms of the financial instrument or contract either1. Require or permit net settlement.2.Provide that the contract can be readily settled net by a means outside the contract.3.Provide for delivery or an asset that puts the recipient in a position not substantially different from net settlement.Mainly as a result of FASB's second requirement, financial instruments such as CMOs and structured notes that are commonly called derivatives are not derivatives as defined by FASB.See FAS 133————A term used to encompass products such as futures, options, and swaps; because of their potentially high risk, special rules often apply. Dresdner Kleinwort Wasserstein financial glossary————Financial instruments or arrangements that derive their value from some underlying stock, bond, commodity or other asset. Futures, swaps, some forwards, options and warrants, and certain mortgage-backed securities are the most common derivative forms. Exchange Handbook Glossary————An investment contract, such as futures and options, which involves the right to buy or sell the underlying instrument at an agreed price. The value of a derivative instrument depends on ( i.e. derived from) the value of another asset. Derivatives can be used to hedge any sort of risk such as foreign exchange or future. For example a company planning to invest money on deposit in the future can buy a derivative to protect against the risk of interest rates falling, i.e., hedging against the interest rate risk. Financial Services Glossary————A derivative is an instrument whose value depends on the performance of an underlying asset or security, which may be a commodity or a financial instrument. London Stock Exchange Glossary————Speculative financial instrument, such as a future, option or swap, based on an underlying. NYSE Euronext Glossary
* * *Derivatives instruments are derived from underlying cash assets that can be bought, sold and traded in a similar way to shares or any other financial instrument. The pricing and performance of derivatives such as futures, options and swaps is largely based on the underlying asset. In practice, derivatives often drive the underlying market and the volume traded in certain futures and options contacts can outstrip the underlying cash market. Derivatives can be traded on an investment exchange, or directly by telephone or computer in an over-the-counter (OTC) market.
Financial and business terms. 2012.