A derivative instrument (or simply derivative) is a financial instrument which derives its value from the value of some other financial instrument or variable. For instance, a stock option is a derivative because it derives its value from the value of a stock. An interest rate swap is a derivative because it derives its value from one or more interest rate indices. The value(s) from which a derivative derives its value is called its underlier(s).
Derivative instruments can be an excellent means of maximizing return on an investment, as well as successfully hedging a financial portfolio.
Since derivative instruments depend on the strength of an underlying security or set of securities, it is important to assess the current status of those securities, as well as accurately project their future movement. For example, if a bond option carries a variable rate that is tied directly to the performance of an underlying stock, the investor would want to look closely at the past history of that stock. Along with the history, the potential investor should also consider the standing of the issuer within its particular industry, and assess the potential for that stock to increase in value during the life of the option. If the prospects seem attractive, investing in the derivative is likely to be a good idea.
Derivative instruments are sometimes issued with the potential for the investor to eventually acquire shares of the underlying security. From this perspective, this means that an investment of this type can be an excellent way to hedge a portfolio against future purchases. Experienced investors often make use of hedging strategies of this type in order to maximize return while also increasing the scope and general value of the portfolio.
In order to identify derivative instruments that show promise of earning a significant return, it is a good idea to work closely with a broker who understands the nature of derivatives. This makes it easier to sort through the many options on the market, and focus on derivatives that are likely to help the investor achieve his or her personal financial goals. A competent broker is usually able to quickly identify strengths and weaknesses associated with the underlying security or securities, and accurately advise the investor of what to expect if the derivative is purchased.
By contrast, we might speak of primary instruments, although the term cash instruments is more common. A cash instrument is an instrument whose value is determined directly by markets. Stocks, commodities, currencies and bonds are all cash instruments. The distinction between cash and derivative instruments is not always precise, but it is a useful informal distinction.
Derivative instruments are categorized in various ways. One is the distinction between linear and non-linear derivatives. The former have payoff diagrams that are linear or almost linear. The latter has payoff diagrams that are highly non-linear. Such non-linearity is always due to the derivative either being an option or having an option embedded in its structure.
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 does vary.
Exhibit 1 lists some standard derivatives and indicates the categories they fall into as stand alone (as opposed to embedded) instruments.
Asian option: non-linear – exotic
Barrier option: non-linear – exotic
Basket option: non-linear – exotic
Binary option: non-linear – exotic
Call: non-linear – vanilla
Cap: non-linear – vanilla
Chooser option: non-linear – exotic
Compound option: non-linear – exotic
Contingent premium option: non-linear – exotic
Credit derivative: non-linear – exotic
Floor: non-linear – vanilla
Forward: linear – vanilla
Future: linear – vanilla
Lookback option: non-linear – exotic
Put: non-linear – vanilla
Quanto: non-linear – exotic
Rainbow option: non-linear – exotic
Ratchet option: non-linear – exotic
Swap: linear – vanilla
Swaption: non-linear – vanilla
Standard derivatives are listed. They are categorized as linear/non-linear and as vanilla/exotic. Usage of the vanilla/exotic distinction does vary, so some of the exotics listed above might be considered vanilla by some professionals. Basket options are an obvious example. Among rainbows, most are exotic, but spread options might be considered vanilla.