In finance Derivatives are securities that have their worth based upon or “derived” from one or more associated assets. Derivatives themselves are simply the contractual documents between one or several parties that denote this. A derivative’s value is derived from the fluctuations in its underlying asset; with the most common associated assets include things like stocks and shares, bonds and commodities, currencies, interest rates and market indexes.

The most common form of derivatives (the actual documents that denote the underlying assets) includes things like futures contracts, options, swaps and forward contracts. There are many other forms of derivatives, some which seem quite outlandish. For example there are derivatives based on weather and temperature. These are however used by farmers who might want to hedge risk against bad weather, that might cause a poor crop cycle or harvest.

Derivatives are usually used for hedge risking purposes, but they can also be used for speculation purposes. An example of this might be, a foreign investor buying American stock from an American exchange. Because they would be using United States Dollars in the purchase of the shares there would be a certain amount of risk due to the exchange rate fluctuations. To hedge this risk of possible exchange rate issues, the investor could purchase futures on currency to lock in a specified exchange rate for when the stock is sold. This means they would know exactly what the rate would be when they or if they decided to sell their shares.

In other words investors, businesses and financial institutions will take out a derivatives agreement on the speculation of the value of the underlying asset, each party thinking or hoping that the other party will be wrong about the future value of the underlying asset and can profit off the difference.

Some institutions often seek out futures contracts that are worth more than the current market value. This is called arbitrage.