Derivative instruments Law and Legal Definition

Derivative instruments are financial instruments which gain their value or change in value from the value and features of the underlying assets. They are treated as an alternative form of investment. They can be classified into exchange-traded derivatives and over-the-counter (OTC) derivatives. They are excellent means for maximizing return on an investment, and for successfully hedging a financial portfolio. Usually, derivatives instruments are categorized on the basis of the relationship between the underlying asset and the derivative; the type of underlying asset; the market in which they trade; and their pay-off profile. Derivative instruments are also associated with risk because any event or market movement that has an adverse impact on the value of the underlying security will also cause the instrument to lose value. For example, the events such as political shifts, disaster situations like floods or hurricanes, or even changes in consumer demand that suddenly causes a serious drop in sales for the company that issues the underlying security can affect the value of derivative instrument.