What is a derivative in investing?

Answer 1

A derivative security is that which is based on (derived from) the price of some other underlying asset. The underlying can be shares of stock, an index, commodities, bonds, currencies, etc.. virtually anything. There are 2 main categories of derivatives: Linear and non-linear. An example of a linear derivative is a Futures Contract which gives the buyer both the right AND obligation to buy the underlying (and receieve delivery of it in the case of commodities etc.) at a specified point in the future when the contract expires. The seller would have the reverse obligation. You can cover (if u bought it u can sell it back) before the contract expires. An example of a non-linear derivative is an Option. An option is the right but NOT the obligation to buy (or sell) the underlying at a specific strike price at (or before if American-style option) a specified expiration date. A Call option is the right to buy and a Put option is the right to sell the underlying. Options are considered non-linear because their prices do not change 1:1 with the underlying but accelerate and have curvature (delta and gamma etc).

Answer 2

A derivative can be defined as a security whose price is dependent or derived from one or more underlying assets. Very simply put it is a contract between two or more parties. The value of a derivative is determined by fluctuations in the underlying asset. These underlying assets include stocks, bonds, currencies, commodities, stock market indexes and interest rates.

A small movement in the value of the underlying asset can cause a large difference in the value of the derivative. In this way derivatives can provide leverage to an investor.

Derivatives are mostly used as a means to hedge risk. For more information on this you should probably check out some if the online trading websites like Reliance Mutual Funds, HDFC, etc.