What is a derivative? – A derivative is an asset whose value is derived from the value of some other asset, known as the underlier or underlying. Derivatives are based on a very wide range of underlying assets. Some examples of underliers are: metals, agricultural commodities, oil, stocks, bonds, and foreign currencies. In all cases, the link between the derivative and the underlying asset is one of value. An option to buy a share at a fixed price is a derivative of the underlying share because if the share price increases then so too does the value of the option.

What are the main characteristics of derivatives? – Nearly every derivative out there is just an agreement between a future buyer and future seller. Most derivatives specify a future price at which some item can or must be sold. This underlying might be some physical commodity such as wheat or oil, or some financial security such as stock or a government bond, or even something more abstract. Most derivatives also specify a future date on or before which the transaction must occur. These are the common characteristics of all derivatives: buyer and seller, underlier, future price, and future date.

In the modern world there is a huge variety of different derivative products. The standard types of derivatives are often referred to as plain vanilla derivatives because they are the simplest and most common. Any derivative that is not a plain vanilla derivative is called an exotic derivative. The more complex derivatives are constructed from the simple types, which are defined in the next section.