Derivatives have their own characteristics that distinguish them from their underlying assets or other forms of financial instruments. The key distinguishing features of derivatives are:
- Derivatives have a maturity or expiration date after which they become worthless or automatically terminate. For example, optional instruments (options and structured options) have a specified life during which the holder can exercise some sort of right. At the end of that life, the contract expires whether that right has been exercised or not.
- A derivative is usually constructed by adding and combining basic components, specifications, triggers and contingencies in order to create a desired payoff pattern. The value of this combination could therefore move with a higher exponential leverage and in the opposite direction with respect to the underlying. The underlying price in a forward contract could be subject to a lower and upper boundary and this creates a new derivative known as a range forward contract. Likewise, adding a barrier to an option in order to associate its payoff with a specific underlying performance led to the creation of a barrier option.
- Derivatives are powerful leverage tools. The value of a derivative can move exponentially relative to the value of its underlying. For instance, a price movement of 5% of the underlying could bring about a 50% value increase/ decrease of the derivative instrument. Notwithstanding, some derivatives have, in addition to their implicit leverage power, an explicit leverage capability such as leveraged options, leveraged swaps, etc.
