Business
Understanding Financial Derivatives
Derivatives are financial contracts whose value is derived from an underlying asset. Learn how they are used for hedging, speculation, and management.
What is it?
A derivative is a financial contract between two or more parties that derives its value from an underlying asset or group of assets. Common derivatives include futures contracts, forwards, options, and swaps. Instead of trading the asset itself, investors trade a contract based on its expected future value. For example, a stock option gives an investor the right, but not the obligation, to buy or sell a stock at a predetermined price within a specific timeframe. The value of this option is 'derived' from the stock's market price.
Why is it trending?
Derivatives are a constant topic in finance due to their dual role in both risk management and speculation. During periods of economic uncertainty and market volatility, interest in derivatives increases as corporations and investors seek to hedge against potential losses. For instance, an airline might use futures contracts to lock in fuel prices. Simultaneously, traders use these instruments to speculate on price movements, amplifying both potential gains and losses. Their complexity and association with major market events, including financial crises, keep them in the headlines.
How does it affect people?
For most individuals, the impact of derivatives is indirect. They allow businesses to manage financial risks, which can help stabilize the prices of goods and services. For sophisticated investors, they provide advanced tools to protect portfolios or achieve higher returns, though this comes with substantial risk. However, the misuse of derivatives has been implicated in large-scale economic downturns, such as the 2008 financial crisis. This shows their potential to affect the wider economy, impacting jobs, mortgages, and retirement funds for the general public.