In terms of finance, what is a derivative?

Money

Derivative: It’s a confusing topic, which is why it was no surprise to see a flurry of activity on a city clerk listserv the other day when one of the clerks received a Notice of Municipal Derivatives Settlement. The answers she got were as foggy as the term.

So, what exactly is a derivative? We decided to simplify it for you using a mnemonic devise using the word “derivative.”

D – Derivative: A Derivative is a financial contract that derives its value based on the performance of another entity.

E – Entity: Entities determine the value of derivative, such as an asset, index, or interest rate.

R – Risk and Reward: Money managers use derivatives for a variety of reasons. By taking a position in a derivative, losses on portfolio holdings may be minimized or offset by profits on the derivative. Derivatives may also gain quicker and allow more efficient access to markets.

I – Interest Rate: One of the factors that may determine the value of a derivative. This is categorized as the “underlying” of a derivative.

V – Value: A derivative’s value is determined based on the performance of another entity such as interest rate, assets, and index.

A – Assets: Another factor that may determine the value of a derivative. This is categorized as the “underlying” of a derivative.

T – Traded: Most derivatives are traded over-the-counter (off-exchange) or on an exchange like a city mercantile exchange.

I – Index: Another factor that may determine the value of a derivative. This is categorized as the “underlying” of a derivative.

V – Variations: Derivatives include a variety of financial contracts–futures, forwards, swaps and options—and variations such as caps, floors, collars, and credit default swaps.

E – Equities: Derivatives are one of three main categories of financial instruments, along with equities, and debt.

For more, check out Wikipedia for information on derivatives.

 

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