Derivatives represent financial contracts whose value derives from underlying assets like stocks, bonds, commodities, or currencies. Common types include options and futures. These versatile instruments serve various functions, including hedging against risks, speculating on price movements, and managing financial exposures. They enable investors to gain exposure to assets without direct ownership.

Derivatives are frequently used for risk management. For instance, a farmer might use a futures contract to stabilize crop prices in the face of commodity price fluctuations. Conversely, traders use them for speculative purposes, aiming to profit from underlying asset price changes. This speculative aspect, however, can involve substantial leverage, amplifying both potential gains and losses.

Additionally, derivatives contribute to the price discovery process by reflecting market participants’ collective expectations about future asset prices. They also offer arbitrage opportunities, allowing traders to exploit price discrepancies between related assets.

Moreover, derivatives provide a means for portfolio diversification. Investors can gain exposure to various assets or asset classes without the need for direct ownership. For instance, they can track the performance of an index like the S&P 500 by trading S&P 500 futures contracts.

While derivatives offer significant advantages, their complexity and potential for amplified losses require a solid understanding before participation in derivative markets.