A derivative is a contract whose value comes from something else. Master that one sentence and the rest of this reading is plumbing.
A derivative is a financial instrument whose value is derived from the value or performance of an underlying. The underlying can be a stock, bond, index, interest rate, currency, commodity, credit event, or even another derivative. The derivative does not require ownership of the underlying. It only references it.
KEY: "Derives from" means the payoff at settlement is calculated by reference to the underlying's price, rate, or event status. No derivative exists without an underlying.
Every derivative contract specifies these elements:
- Underlying. The asset, rate, index, or event being referenced (S&P 500, 3-month SOFR, WTI crude, USD/EUR, a defined credit event).
- Notional amount (or contract size). The quantity of the underlying the contract represents. For a futures contract on crude oil, one contract typically equals 1,000 barrels.
- Price, rate, or strike. The agreed reference level at which the contract settles or can be exercised.
Common mistakes
- Treating the notional as an exchanged cash amount. The $200 million notional in a swap is a reference quantity, not a principal payment. Only net interest flows trade hands.
- Calling all OTC markets "unregulated." Post-2008 reforms require clearing and reporting for many standardized swaps. The accurate contrast is less standardized and less transparent, not unregulated.
- Confusing physical delivery with cash settlement. Index and rate derivatives must cash settle. Commodity and single-name equity contracts may allow physical delivery if held to expiration.
Bottom line
- A derivative derives value from an underlying asset, rate, or index. The contract is the instrument; the underlying is the reference, owned by neither party.
- Five core features: underlying, notional/size, price (or rate), expiration date, settlement method (physical vs cash).
- Notional scales the payoff but is rarely exchanged in full; in a swap only the net flows trade hands.
- Exchange-traded = standardized, centrally cleared, transparent, low counterparty risk. OTC = customized, bilateral, less transparent, higher counterparty risk.
Exam shortcut
If the question says "standardized contract size and central clearing," answer exchange-traded. If the question says "negotiated terms tailored to a specific exposure," answer OTC. When a swap or forward question quotes a large round number with no payment, that number is the notional, not a cash flow. CFA Institute does not endorse, promote, review, or warrant the accuracy or quality of the products or services offered by FreeFellow LLC.
The full lesson (about 1,741 words, 12 min read) adds 2 worked examples, all 5 common mistakes, a self-check, free in the app.
Learning objectives
- instrument and market features
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