What are derivatives in finance?

Derivatives in finance are defined as financial contracts whose value is directly linked to the price of an underlying asset. This associated asset can include stocks, bonds, commodities, interest rates, or market indices, among others. The primary function of derivatives is to manage risk or to speculate on the future price movements of these underlying assets. By using derivatives, investors can hedge against potential losses in their underlying assets or take leveraged positions to amplify their potential returns. This intricate connection to the underlying asset is what differentiates derivatives from other investment instruments.

In contrast to derivatives, stocks and bonds represent ownership in a company or debt obligations, respectively, and do not derive their value from another source. Direct investments in real estate are tangible investments in property, while fixed deposits are low-risk interest-earning accounts with a bank. These other options do not share the defining characteristic of being value-dependent contracts, hence they are not classified as derivatives.