What are 'financial derivatives'?

Financial derivatives are complex financial instruments that derive their value from the performance of underlying assets, such as stocks, bonds, commodities, currencies, interest rates, or market indexes. This means that the value of a derivative is contingent upon the price movements or values of these underlying entities. Common types of financial derivatives include options, futures, and swaps, which are often used for hedging purposes or speculating on price movements without actually owning the underlying assets themselves.

The focus on the relationship between the derivative and the underlying asset is crucial. Investors use derivatives to manage risk or enhance returns, taking advantage of the leverage they offer due to the lower capital outlay required compared to direct ownership of the underlying assets. This key characteristic distinguishes derivatives from other types of financial instruments, which may be more directly tied to ownership or intrinsic value.

In contrast, other options refer to different financial concepts. Direct equity ownership denotes owning shares in a company (which is not derived). Physical assets imply a tangible form, lacking the derivative component. Long-term securities issued by corporations represent direct investments rather than instruments derived from underlying assets. Understanding derivatives is fundamental for navigating modern financial markets, highlighting their importance in various investment strategies.