Derivative.

In plain English

A derivative does not hold the underlying asset; it is an agreement between parties whose payoff is calculated from that asset's price. Options, futures, forwards, and swaps are the main families, and every one of them sets a payoff rule tied to a reference price. Derivatives get used for two different purposes: hedging, which reduces an existing exposure, and speculation, which creates a new one. Because only a fraction of the notional value is posted up front, a derivative can carry a much larger exposure than the cash committed to it. Some trade on exchanges with a clearinghouse guaranteeing performance, and others are private contracts where each side depends on the other.

01Why it matters

Derivatives let a small amount of money control a large exposure, which is why the same contract can reduce risk for a hedger and multiply it for a speculator.

02The math, step by step

One equity option contract covers 100 shares. At a stock price of 80, that is 8,000 of exposure controlled by a premium of maybe 300. A 5 percent move in the stock is 400 on the underlying, which is more than the entire premium paid.

Illustrative example. The amounts here are hypothetical, chosen to show how the math works, not real quoted rates or figures.

03What this is NOT

04Receipts

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