What defines a derivative in finance?

A derivative in finance is defined as a financial instrument whose value is based on the value of another underlying asset. This underlying asset can be stocks, bonds, commodities, currencies, interest rates, or market indexes. The primary characteristic of derivatives is that they derive their value from fluctuations in the price of the underlying asset, hence the name "derivative."

This definition is crucial because it distinguishes derivatives from other types of financial instruments. For example, an asset that is based solely on cash flow doesn't necessarily depend on the value of another asset, while investments that guarantee returns might not involve any underlying assets at all. Similarly, fixed-income securities issued by corporations have their own valuations and are not dependent on external underlying assets in the sense that derivatives are. Understanding this relationship is fundamental for analyzing financial risks and rewards associated with derivative contracts, as they can be used for hedging, speculation, or leveraging positions in the markets.