The simplest way to explain a derivative would be to say that it is a financial agreement between two parties. It derives its value from a real good or type of stock. The value of these financial derivatives will be based on the future expected price for something. So in a lot of cases the person selling the derivative will agree to provide something in the future at a price that is agreed upon now. Some people will use this as a form of investment in the hope of making a lot of money in the future.
Financial Derivatives and Leverage
An important benefit of using financial derivatives is that it allows investors to get leverage; a technique whereby they can multiply gains or losses. Most people will benefit from this type of leverage because one of the most common forms of it is a mortgage. When we take out this form of leverage we only make a small initial investment but get to control a much larger asset – our house. A similar thing happens with financial derivatives. If an investor believes that the value of something is going to increate in the future then the fact that they are agreeing to a lower price now means that they can make a lot of money later. The downside of all this is though, that if they are wrong and the value of the good or stock falls then this will mean that they end up paying a lot more than the current value.
Financial Derivatives and Hedging
Another idea that is closely associated with financial derivatives is hedging; this is a technique whereby we try to reduce risks in the future that occur due to market fluctuations. Imagine there is a farmer who grows potatoes and relies on diesel to power his tractor; he knows that the price of diesel is always fluctuating so he will be worried about the future. One way that he can reduce his risk is by making an agreement with the diesel supplier that he will supply a certain amount of bags of potatoes for the amount of fuel he needs at a later date. This way no matter what happens with the price of diesel he will already have an agreed upon amount that he needs to pay. The person supplying the diesel also benefits because they don’t have to worry about the rising price of potatoes. Of course either side could lose out if it later turns out that the cost of the product they need is a lot cheaper than they expected.
One of the main drawbacks of financial derivatives is that it is open for abuse. There have been a number of famous examples where investors got in way over their heads and this has even managed to bring down some well known financial institutions. One of the most famous examples of this was the Barrings Bank which one of their team became a rogue trader on the derivatives market.