Derivative Definition. A Derivative is a contract whose value moderates in relation to the price movements of a related or underlying security, future or other physical instrument. Stocks, commodities or currency are typically the “underlying”. There are many kinds of derivatives, with the most notable being swaps, futures, and options. However, since a derivative can be attached to any sort of security, the breadth of possible derivatives is nearly endless. Thus, a more acceptable definition of a derivative is an agreement between two parties that is contingent on a future outcome of the underlying. Derivatives, such as swaps, futures, and options, which have a theoretical face value that can be calculated using formulas, such as the Black-Scholes pricing model, are frequently traded on open markets before their expiration date as if they were assets. The downside risk is that the use of derivatives can result in large losses because of the use of leverage, or borrowing. Derivatives, especially in forex markets, allow investors to earn large returns from small movements in the underlying asset’s price. However, investors could lose large amounts if the price of the underlying moves against them significantly. The need to recapitalize insurer American International Group (AIG) with $85 billion of debt provided by the U.S. federal government was due to losses incurred by an AIG subsidiary on Credit Default Swaps (CDS) it had written. Recent reform legislation assigned oversight of derivatives to the CFTC.
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