What are derivatives in the context of finance?

Derivatives are financial instruments designed to derive their value from an underlying asset, such as stocks, bonds, commodities, interest rates, or market indices. This relationship allows derivatives to serve various purposes, including hedging risk, speculating on future price movements, and seeking arbitrage opportunities.

By definition, a derivative's value changes in response to changes in the price of the underlying asset, making it a pivotal tool for investors looking to manage their exposure to market fluctuations. Common types of derivatives include options, futures, and swaps, each of which has unique characteristics based on the underlying asset it is tied to.

This understanding helps clarify the role of derivatives in financial markets, distinguishing them from other financial instruments that might have fixed values, guaranteed returns, or no relation to specific assets. Such distinctions are essential for anyone engaged in investment management or financial analysis, as they highlight the complexities and functionalities of various financial products.