Which of the following is an example of a financial derivative?

Which of the following is an example of a financial derivative?

• A. An investment in real estate
• B. A mutual fund holding multiple securities
• C. An option or futures contract
• D. A primary stock issue

Answer: (C)

An option or futures contract is classified as a financial derivative because it derives its value from an underlying asset. Derivatives are financial instruments whose value is contingent upon the performance of an underlying entity, which can be stocks, bonds, commodities, interest rates, or market indexes. Both options and futures contracts are commonly used to hedge against risks or to speculate on price movements of the underlying assets. For instance, an option contract gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified timeframe. A futures contract, on the other hand, obligates the parties to transact at a predetermined future date and price. These instruments serve critical functions in the financial markets, including risk management and price discovery. In contrast, the other options do not qualify as derivatives. Investing in real estate is a direct investment in physical property. A mutual fund holding multiple securities is an investment vehicle that provides investors with exposure to a diversified portfolio of assets. Lastly, a primary stock issue refers to the first sale of stock by a company to the public and represents a direct ownership stake in the company rather than a derivative instrument.

An option or futures contract is classified as a financial derivative because it derives its value from an underlying asset. Derivatives are financial instruments whose value is contingent upon the performance of an underlying entity, which can be stocks, bonds, commodities, interest rates, or market indexes. Both options and futures contracts are commonly used to hedge against risks or to speculate on price movements of the underlying assets.

For instance, an option contract gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified timeframe. A futures contract, on the other hand, obligates the parties to transact at a predetermined future date and price. These instruments serve critical functions in the financial markets, including risk management and price discovery.

In contrast, the other options do not qualify as derivatives. Investing in real estate is a direct investment in physical property. A mutual fund holding multiple securities is an investment vehicle that provides investors with exposure to a diversified portfolio of assets. Lastly, a primary stock issue refers to the first sale of stock by a company to the public and represents a direct ownership stake in the company rather than a derivative instrument.