Derivatives

In finance, derivatives are financial instruments whose value is derived from the value of an underlying asset, such as stocks, bonds, commodities, currencies, or interest rates. These contracts are agreements between two or more parties, and they can be used for hedging, speculation, or arbitrage. The price of a derivative fluctuates depending on the price movement of its underlying asset. derivatives are complex instruments that can amplify both gains and losses, making them risky if not properly understood.

Derivatives meaning with examples

• A farmer might use agricultural derivatives like futures contracts to hedge against price fluctuations in corn, guaranteeing a selling price for their crop before harvest. This helps manage financial risk associated with crop yields.
• Investors could buy or sell options contracts on a specific stock, offering the right, but not the obligation, to buy or sell that stock at a predetermined price before a set date. This is often used for short term gains.
• Corporations may utilize interest rate swaps to convert a floating-rate debt to a fixed-rate debt or vice versa, aiming to optimize their borrowing costs and manage interest rate risk in an unstable market.
• Speculators may use currency futures to bet on the direction of exchange rates, aiming to profit from the anticipated changes. This carries high risk in highly volatile environments.
• The mortgage-backed securities (MBS) sold during the 2008 financial crisis are a type of derivative, pooling mortgage payments and repackaging them into investment products. These highly leveraged products exposed systemic risk.