Derivative Instrument

Derivative instruments (or simply derivatives) are a category of financial instruments that includes options, futures, forwards and swaps. While there is general agreement among financial practitioners as to which instruments are considered derivatives and which are not, coming up with a general definition that conforms precisely to that understanding is difficult.

The name “derivative” reflects a sense that derivatives somehow derive value at one or more future points in time based on observables such as prices, interest rates, exchange rates, indexes, events of default or even the amount of rainfall at a given location over a given year.

A reasonable characterization of derivative instruments is that they are pure wagers divorced from any investment. For example, gold futures are considered derivatives because they entail the risk of investing in gold without any actual investment in gold. Indeed, during the 1990s, as Bankers Trust and other financial institutions expanded sales of customized derivatives, there was concern the instruments might be regulated as gambling contracts, rendering them illegal in most jurisdictions.

While all derivatives can be used for speculation, some facilitate legitimate hedging. For example, a wheat farmer might sell wheat futures while his crop is in the ground as a means of locking in a particular sale price at harvest. Due to their ability to mimic certain transactions without actually entailing those transactions, derivatives have also been widely used to manipulate accounting results or for tax avoidance. Accounting rules and tax laws have evolved to minimize opportunities for such use.

Derivative instruments are categorized in various ways. They can be distinguished as either linear and non-linear. The former have payoff diagrams that are linear or almost linear. The latter have payoff diagrams that are highly non-linear due to the derivatives either being options or having options embedded in their structure. Futures, forwards and swaps are linear. Most other derivatives are non-linear.

Derivative instruments are distinguished by being either physically settled or cash settled. Some allow one party to the contract to elect either physical or cash settlement. Derivatives are also distinguished between those that are traded on exchanges and those that trade over the counter (OTC).

A somewhat arbitrary distinction is between vanilla and exotic derivatives. The former tend to be simple and more common; the latter more complicated and specialized. There is no definitive rule for distinguishing one from the other, so the distinction is mostly a matter of custom. Usage varies.

Exhibit 1 lists some standard derivative instruments.