For all its current importance in finance, the term ‘derivative’ is of recent origin. Just a generation ago, readers may have assumed that the term related to mathematics (as in ‘second derivative of a function’) or chemistry (as in ‘derivatives of carbon’). The acclaimed book Inside the Financial Futures Markets by Mark J. Powers and D. Vogel, published in 1984 and dealing exclusively with (what are now called) derivatives, did not use the word even once. This chapter looks at what derivatives are, how they may be classified and finally, what they are not.

Definition of derivative

A conventional and commonly used definition is as follows:

Thus, a gold futures contract derives its price from the price of gold, which is the ‘underlying’ asset; an option on crude oil derives its price from the price of crude oil; a currency swap derives its value from the exchange rate of the currencies involved.

The first, and minor, problem with this definition is that the ‘underlying’ may not be an asset in the conventional sense: the underlying may be a liability (such as a bond) or an index (like the Standard & Poors or S&P 500 share index). However, this is a semantic issue. Mathematically, a liability is a negative asset. An index is the average value of a set of assets or liabilities. Whether something is an asset or liability also depends on whose perspective is involved.

The second and bigger problem is that certain instruments now widely considered as ‘derivatives’ are based on the occurrence of events (such as a debt default), which do not themselves have a ‘price’ in the common sense meaning of the term.