Lesson 1 of 5 · 13 min
What a derivative is and how a contract is built
A derivative is a contract to exchange cash flows in the future, with an amount that depends on an underlying, so it reshapes the underlying's performance instead of simply passing it through.
In short
- A derivative is a financial contract whose value derives from the performance of an underlying: an asset, a group of assets, or a variable such as an interest rate or a credit index.
- Spot (cash) markets exchange assets now at spot prices; derivatives agree today on an exchange that happens later.
- Every contract names its counterparties, its underlying, its maturity (when it ends and settles), its contract size (notional) and a pre-agreed price.
- The buyer of a derivative gains exposure similar to a long position in the underlying; the seller has exposure similar to a short position.
- Settlement can be by delivery of the underlying or by paying the cash difference. Counterparty credit risk is the risk the other side cannot pay.
- A stand-alone derivative is a separate contract; an embedded derivative sits inside another instrument, such as a callable, puttable or convertible bond.
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