What are Derivatives?
A derivative is a financial instrument whose value is derived from an underlying asset, index, or interest rate. The four main types are futures, forwards, options, and swaps. Some trade on organised exchanges (futures, listed options), others over-the-counter (OTC) between private counterparties. Market participants use derivatives to hedge risk, speculate on price movements, and exploit arbitrage opportunities. The 2025 BIS Triennial Survey put the notional value of outstanding OTC derivatives at US$846 trillion in mid-2025, one of the largest segments of the global financial system.
Why it matters
A derivative is a side contract. The asset itself (wheat, the AUD/USD rate, the ASX 200 index) trades in one market. The derivative is a separate legal agreement whose payoff depends on what that asset does. A farmer who locks in next quarter's wheat price has not bought or sold any wheat yet, but has shifted the risk of a price drop onto someone else. That separation between owning the asset and owning the cash-flow rights tied to it is what makes derivatives flexible enough for hedging, speculation, and arbitrage all at once.
Worked examples
A Western Australian wheat farmer worries that wheat prices will fall before her harvest in three months. She sells wheat futures contracts at the current futures price of A$330 per tonne.
She has locked in A$330 per tonne for her harvest. If spot wheat falls to A$300 by delivery, her futures position gains A$30 per tonne, offsetting the lower price she receives in the spot market. If spot wheat rises to A$360, the futures lose A$30 per tonne and her net revenue stays at A$330. She trades upside for certainty, the essential pattern of a hedge.
A hedge fund believes the RBA will cut the cash rate next quarter, which would push the AUD lower. The fund sells AUD/USD forwards through an international bank.
If the AUD falls as expected, the forward locks in the higher rate and the fund profits on the spread. If the AUD rises instead, the fund loses on the forward. The fund holds no Australian dollars yet takes a directional view on price, the essential pattern of speculation. The bank on the other side may itself be hedging exposure from another client, which is how derivatives transfer risk between parties.
Common mistakes
- âDerivatives are inherently risky gambling instruments. They can either increase or reduce risk depending on use. A farmer using futures to lock in a price is reducing risk. A speculator taking a leveraged position with no underlying exposure is adding risk. The instrument is the same, the function differs.
- âDerivatives create new risk in the system. They do not generate risk, they transfer it. A wheat futures contract has two sides. The seller takes off price risk, and the buyer (a flour mill, a speculator) takes it on. Total risk in the system is unchanged, only the holder shifts. The systemic concern is concentration of risk and counterparty default, not creation of risk.
- âDerivative payoffs are tied only to stock prices. Underlying assets span equities, interest rates, currencies, commodities, credit events, weather, electricity, even carbon emissions. Interest rate derivatives are by far the largest category in terms of notional outstanding.
Revision bullets
- â˘Value is derived from an underlying asset or rate
- â˘Four main types are futures, forwards, options, swaps
- â˘Used for hedging, speculation, and arbitrage
- â˘Zero-sum contracts where one side's gain equals the other's loss
- â˘Traded on exchanges or over-the-counter (OTC)
- â˘OTC notional â US$846 trillion (BIS, mid-2025)
Quick check
A derivative's value depends primarily on:
An Australian exporter who sells US dollars forward to lock in an exchange rate is engaged in:
Connected topics
In learning paths
Sources
- Hull, John C. Options, Futures, and Other Derivatives. 11th ed. Pearson, 2022. ISBN 978-0-13-693997-9.Anchor textbook for undergraduate derivatives. Chapter 1 introduces the four main contract types and the role of exchange-traded versus over-the-counter markets.
- Bank for International Settlements. Triennial Central Bank Survey of foreign exchange and OTC derivatives markets in 2025. BIS, September 2025.Authoritative source for global derivatives market size. Confirms OTC notional outstanding of US$846 trillion at end-June 2025, the largest year-on-year rise since 2008.
- Australian Securities Exchange. Trade our derivatives market: overview. ASX, accessed 2026.Primary local reference for Australian-listed derivatives across equity, interest rate, energy, grain, and environmental product classes.
- International Swaps and Derivatives Association. ISDA Launches New Report Setting out the Uses and Value of Derivatives. ISDA Press Release, March 2025.Industry-side overview of how corporates, asset managers, and banks use derivatives for risk transfer, return enhancement, and capital allocation.