What are derivatives
A simple guide to derivatives to better understand what DIVA Protocol is about
A derivative is a financial product that derives its value from the outcome of an underlying event and a payoff function that defines the payout for each possible outcome. In traditional finance, derivatives are used for the sake of speculation or protection against adverse events (also referred to as hedging).
The most basic example of a derivative is a sports bet. In a sports bet, the payout is $1 if Team A wins and $0 otherwise. Another example is an insurance product that pays out $1 if the house burns down and $0 otherwise. The basic idea of a derivative is visualized below:
Visualization of the basic concept of a derivative
This concept can be generalized by allowing any event as underlying and any payoff function. For example, we could take the Bitcoin price at some future point in time as the underlying event and attach a linear payoff function that starts at $40k and caps out at $80k. The holder of such a derivative asset will benefit if the price of Bitcoin goes up. The holder is said to be long the underlying asset.
Long payoff chart
We can also construct a derivative that will benefit as the Bitcoin price goes down by using a payoff function like this:
Short payoff chart
The holder of such a derivative asset is said to be short the underlying asset. This can be a convenient alternative to shorting an asset in one single step.