Learn The Stock Market Lesson - What are Financial Derivatives?

Most of us have heard about the controversial uses of derivatives, the debates between whether they should or should not be regulated, and the amount of oversight there should be on them. Derivatives are the complex financial instruments that contributed to not only the collapse of the giant insurer AIG but also 3 of the largest bankruptcies in American history – WorldCom, Enron, and Global Crossing. I will be discussing a little more in-depth about its debate in my next post.

So what exactly are derivatives?
Derivatives refer to a general class of investments, rather than a specific type of investment like stocks or bonds. As the name suggests, derivatives are investment vehicles that are derived from other types of investments. In other words, it is a security whose price is dependent upon or derived from one or more underlying assets.

They are contracts between 2 or more parties and its value is determined by the fluctuation of another underlying asset, such as a commodity, equities (stocks), loans (bonds), currencies and more. For example, the changing value of crude oil futures depends primarily on the movement and the fluctuation of oil prices.

The most common types of derivatives are futures contracts, forward contracts, options and swaps, which I will be discussing further in a later post.

How are derivatives different from stocks and bonds?
Stocks – represent shares of ownership in something tangible, such as a corporation
Bonds – also represents something tangible since they are promises of loan repayments, or IOUs from a borrower
Derivatives – hybrid investments based on these more basic investments. And because they are hybrids, investing in derivatives is more complex, and often far more risky than investing in stocks or bonds.

What’s the purpose of derivatives?
Derivatives are generally used as a financial instrument to hedge, or reduce, risk for one party but can also be used for speculative purposes. Investors sometimes purchase and sell derivatives to manage the risk associated with the underlying asset, to protect against fluctuations in value, or to profit from periods of inactivity or decline. Don’t forget that these techniques can be quite complicated and risky.