Define: Derivative Instrument

De­riv­a­tive in­stru­ments (or sim­ply de­riv­a­tives) are a cat­e­gory of fi­nan­cial in­stru­ments that in­cludes op­tions, fu­tures, for­wards and swaps. While there is gen­eral agree­ment among fi­nan­cial prac­ti­tion­ers as to which in­stru­ments are con­sid­ered de­riv­a­tives and which are not, com­ing up with a gen­eral de­f­i­n­i­tion that con­forms pre­cisely to that un­der­stand­ing is dif­fi­cult.

The name “de­riv­a­tive” re­flects a sense that de­riv­a­tives some­how de­rive value at one or more fu­ture points in time-based on ob­serv­ables such as prices, in­ter­est rates, ex­change rates, in­dexes, events of de­fault or even the amount of rain­fall at a given lo­ca­tion over a given year.

A rea­son­able char­ac­ter­i­za­tion of de­riv­a­tive in­stru­ments is that they are pure wa­gers di­vorced from any in­vest­ment. For ex­am­ple, gold fu­tures are con­sid­ered de­riv­a­tives be­cause they en­tail the risk of in­vest­ing in gold with­out any ac­tual in­vest­ment in gold. In­deed, dur­ing the 1990s, as Bankers Trust and other fi­nan­cial in­sti­tu­tions ex­panded sales of cus­tomized de­riv­a­tives, there was con­cern the in­stru­ments might be reg­u­lated as gam­bling con­tracts, ren­der­ing them il­le­gal in most ju­ris­dic­tions.

While all de­riv­a­tives can be used for spec­u­la­tion, some fa­cil­i­tate le­git­i­mate hedg­ing. For ex­am­ple, a wheat farmer might sell wheat fu­tures while his crop is in the ground as a means of lock­ing in a par­tic­u­lar sale price at har­vest. Due to their abil­ity to mimic cer­tain trans­ac­tions with­out ac­tu­ally en­tail­ing those trans­ac­tions, de­riv­a­tives have also been widely used to ma­nip­u­late ac­count­ing re­sults or for tax avoid­ance. Ac­count­ing rules and tax laws have evolved to min­i­mize op­por­tu­ni­ties for such use.

De­riv­a­tive in­stru­ments are cat­e­go­rized in var­i­ous ways. They can be dis­tin­guished as ei­ther lin­ear and non-lin­ear. The for­mer have pay­off di­a­grams that are lin­ear or al­most lin­ear. The lat­ter have pay­off di­a­grams that are highly non-lin­ear due to the de­riv­a­tives ei­ther being op­tions or hav­ing op­tions em­bed­ded in its struc­ture. Fu­tures, for­wards and swaps are lin­ear. Most other de­riv­a­tives are non-lin­ear.

De­riv­a­tive in­stru­ments are dis­tin­guished by being ei­ther phys­i­cally set­tled or cash set­tled. Some allow one party to the con­tract to elect ei­ther phys­i­cal or cash set­tle­ment. De­riv­a­tives are also dis­tin­guished be­tween those that are traded on ex­changes and those that trade over the counter (OTC).

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 varies.

Ex­hibit 1 lists some stan­dard de­riv­a­tive in­stru­ments.