Derivatives are similar to insurance in that both allow for the transfer of risk from one party to another. As everyone knows, insurance is a financial contract that provides protection against loss. The party bearing the risk purchases an insurance policy, which transfers the risk to the other party, the insurer, for a specified period of time. The risk itself does not change, but the party bearing it does. Derivatives allow for this same type of transfer of risk. One type of derivative in particular, the put option, when combined with a position exposed to the risk, functions almost exactly like insurance, but all derivatives can be used to protect against loss. Of course, an insurance contract must specify the underlying risk, such as property, health, or life. Likewise, so do derivatives. As noted earlier, derivatives are associated with an underlying asset. As such, the so-called “underlying asset” is often simply referred to as theunderlying
, whose value is the source of risk.1
In fact, the underlying need not even be an asset itself. Although common derivatives underlyings are equities, fixed-income securities, currencies, and commodities, other derivatives underlyings include interest rates, credit, energy, weather, and even other derivatives, all of which are not generally thought of as assets. Thus, like insurance, derivatives pay off on the basis of a source of risk, which is often, but not always, the value of an underlying asset. And like insurance, derivatives have a definite life span and expire on a specified date.