A derivative is a special type of financial instrument whose value is based off of (or derived from) the value of another financial instrument. They are also financial contracts that create an obligation between two parties. The exact nature of this obligation depends on the type of derivative, but these contracts are regulated by governmental agencies or other regulatory bodies. For instance, the U.S. Securities and Exchange Commission operates a derivatives clearing house to settle the payment of derivatives, while Euronext is a regulated market for exchanging derivatives.

The main types of derivatives are forwards, futures, options, swaps, warrants, LEAPS, baskets, and swaptions. Some of these types can be further broken down. For instance, options can be broken down into calls and puts, each of which acts differently.

Because derivatives are based off of the value of another asset, index, or instrument, they are recorded on a balance sheet differently. Instead of recording the notional value of the derivative (how much was paid for it), the market value (how much the derivative is worth if traded) is recorded on the balance sheet.

Derivatives allow investors to do two things. First, they can help mitigate an investor’s risk due to the value of an asset fluctuating. This is called “hedging.” When an investor hedges, they enter into a contract to buy an item at a given price in the hopes that the price does not significantly change and that they would not have gotten a better price down the road. Derivatives also allow investors to speculate (guess whether a given product’s price will rise or fall), thereby increasing their profit margin.