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Definition of 'Derivative'

A derivative is a financial instrument or security whose price is based on or derived from one or more underlying assets. It is important to note that a derivative is a contract between multiple parties (usually two). The contract determines what the underlying asset is and the terms of delivery of that asset. Common underlying assets are market indexes (e.g. S&P500), currencies, interest rates, commodities, stocks, and bonds. The value of the derivative fluctuates based on the value of the underlying asset.

The types of derivatives are only limited by one's imagination. Weather derivatives are popular instruments for traders or farmers that want to hedge their crop sales. Traditionally farmers would hedge the price of their crop production with commodity derivatives such as corn futures. However, these futures would fluctuate depending on weather patterns such as number of sunny days and rainfall. This made it logical for weather futures to be traded as this was the "economic indicator" that was being watched to determine the prices of the corn futures.

Derivatives are used for three main purposes:
  1. Hedging - protecting your underlying asset against adverse movements.
  2. Investing - gaining exposure to an asset without buying or selling that asset.
  3. Speculation - market timing and trading for shorter term profits - usually measured in minutes, hours, or days.

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