Can someone explain to me the concept of derivative in finance? It is
a kind of investment vehicle that works better than stock and bond
which I understand but I can't figure out this derivative
thing.

Hi chibinh,

There are many different kinds of derivatives, and I can only give you
a general introduction here.  Wikipedia's definition is a good
starting point:

"A derivative is a financial contract whose payoffs over time are
derived from the performance of assets (such as commodities, shares or
bonds), interest rates, exchange rates, or indices (such as a stock
market index, consumer price index (CPI) or an index of weather
conditions)."

With a derivative, you are neither buying part of a company, as with a
stock, nor lending to a company, as with a bond.  Instead, you are
making some other kind of bet or deal with some other party where the
payoff depends on what some asset (or rate or index) will do in the
future.

Options and futures are common forms of derivatives.

With an option, one party pays another for the right to buy or sell a
specified security at a specified price within a specified period of
time.  The value of this right to buy or sell will fluctuate depending
on the relationship between the option price and the current market
price.  For example, if you have an option to buy Microsoft at $100 a
share, the option is valuable while Microsoft is trading at $200 a
share, and worthless while Microsoft is trading at $50 a share, except
for its speculative future value.

With a futures contract, one party agrees to pay another party a
specified price for a specified asset at a specified future time. 
Depending on market conditions, this may or may not be a good deal
when the time comes, but having it nailed down can reduce a party's
risk.

Derivatives are not necessarily better than stocks or bonds.  They can
be used to hedge, or reduce risk, or they can be used for speculation,
offering a lot of risk for the possibility of a big reward.


Additional Links

Investopedia defines derivatives
http://www.investopedia.com/terms/d/derivative.asp

Wikipedia on deriviatives
http://en.wikipedia.org/wiki/Derivative_(finance)

Our crosstown rivals over at Ask Yahoo! tackled a similar question in 2002.
http://ask.yahoo.com/20020219.html

Wikipedia on options
http://en.wikipedia.org/wiki/Option

Wikipedia on futures
http://en.wikipedia.org/wiki/Futures_contract

Wikipedia on swaps
http://en.wikipedia.org/wiki/Swaps

The Derivatives FAQ from Numa, a website that specializes in derivatives
http://www.numa.com/ref/faq.htm


If this explanation is not clear enough or you need more information,
please ask for a clarification, and I will try to help.

--efn

I have got to learn how to drive a derivative car to travel through
today's financial trafic. Thanks.