What is a financial derivative?

A financial derivative is a contract whose value is derived from an underlying asset. This definition captures the essence of derivatives, which include instruments like options, futures, and swaps. These contracts do not reflect any intrinsic value of their own; instead, their worth fluctuates based on the price movements of the underlying asset, such as stocks, commodities, interest rates, or currencies. Derivatives can be used for various purposes, including hedging against risks, speculating on price movements, or gaining access to additional leverage in investment strategies.

Understanding derivatives is critical in financial management, as they can significantly affect the valuation of portfolios, risk exposure, and the overall dynamics of financial markets. They serve different functions in the financial ecosystem, from facilitating price discovery to enabling risk management through hedging strategies.

Other choices, while relevant to finance, do not accurately characterize what a financial derivative is, focusing instead on prediction methods or other financial instruments without the specific relationship to an underlying asset.