What is a Derivative?

The value of the contract is based upon or derived from, the value of the underlying asset. This is why it’s called a derivative investment.

Hey everybody. This is Jason with the Coach’s Hangout. I just received this package from Purolator. Let’s open it up and take a look what’s inside.

Okay. This looks like an agreement of some sort, and let me see here. It says, “This contract gives Jason Knell, that’s me, the option to buy my colleague’s (Andre) house, at any time in the next six months for $1 million.” Wow! What do you think I should do? Well, my family is actually in the market for a bigger house. Should I exercise this contract? Hmm, let’s take a closer look. It also says that I can sell this contract to anybody else. Now this is really interesting. What a tough decision to make. Let me ask you a question. What do you think this contract is worth? What else would you need to know? Well, I actually have the option to buy Andre’s house for 1,000,000 – but what is it actually worth today? And is it in the Toronto market, where land is limited and expensive, or is it way up north, where land is somewhat plentiful and well, hopefully, not quite as expensive? Does the house look like? Like the picture provided, or …?

To understand the value of this contract, we would really need to know what the house is actually worth right now. So for example, if it’s worth one and a half million dollars and I have the option to buy it for only $1 million, then this contract is extremely valuable to me, to the tune of $500,000. On the other hand, if the house is only worth $600,000 then this contract is pretty much worthless to me and I’ll probably just let it expire. So as you can see, the value of this contract is based upon, or as we like to say, “derived from” the value of the underlying asset. In this case, the house. If you’re taking the Canadian Securities Course, or obviously a Derivatives Course, you’re going to learn about the various types of derivative contracts, such as rights, warrants, options contracts, futures that trade on an exchange, forwards that trade over the counter, swaps, and many other products.

These derivative contracts all have different features, but they all follow the same basic principle. The value of the contract is based upon or derived from, the value of the underlying asset. This is why it’s called a derivative investment. Now, the underlying asset would not typically be a house. I just used that as an analogy because it’s something that most students will be familiar with. It could be a commodity such as gold, silver, oil, or a financial asset, such as a stock or even a future cashflow. While derivative contracts can be complex, at SeeWhy Learning, we have a real knack for simplifying things using stories, analogies, memory aids, or just simply a different way of looking at things. So be sure to check out our full line of study tools at SeeWhyLearning.com and be sure to poke around our YouTube channel to get a good sense of how we simplify things. Thanks for dropping by the Coach’s Hangout and good luck on your upcoming exams.