What are derivative products

The term "derivative" indicates the fundamental feature of these products: their value derives from the performance of the value of an asset or from the occurrence in the future of an event which can be objectively observed.

The asset, or the event, which can be of any type or kind, represent the "underlying" element of the derivative product.

The relationship – which can be determined via mathematic functions – which ties the value of the derivative to the underlying element represents the financial result of the derivative, also call the "pay-off".

Derivative products are mainly used for three purposes:

• reducing the financial risk of a pre-existing portfolio (hedging purpose);
• undertaking exposures to risk for the purpose of achieving a profit (speculative purpose);
• achieving a profit lacking risk by means of combined transactions on the derivative and on the underlying element capable of seizing any valorisation differences (arbitrage purpose).

The most complex problem of derivatives is, from time immemorial, that of determining their value or, better still their assessment. It is a particularly important aspect and, at the same time, critical, since it requires complex analysis activities.

We have already said that it varies in relation to the performance of the underlying element, according to a relationship, of precisely each derivative, represented by a mathematical function. In this sense, it is established that the value of the derivative produced is associated with both the underlying element and the pay-off.

The estimate of the value of the derivative products, at a given moment in time, requires the ability to simulate the possible future scenarios of the underlying element for the purpose of determining, for each scenario, the consequent value of the pay-off. Therefore, the value of the derivative is the average of the values adopted by the pay-off weighted by the probabilities of occurrence of each scenario (the most probable scenario will have a greater weight), discounted by the financial value of the time (and in other words at the time of valuation).

Structured products are different from derivative products, and comprise a combination, in a single product, of one or more financial products with one or more derivative products, in such a way as to structurally change the original risk/return profile of the individual products. A typical example are structured bonds, in relation to which a specific investor education guide is available on the Consob website.