Derivative contracts are agreements between at least two parties (buyers and sellers). The value of a derivative is based on a financial asset or set of assets, such as a security or index.

Common underlying financial assets include:

  • Bonds
  • Currencies
  • Interest rates
  • Commodities
  • Stocks
  • Market indexes

Common derivatives include:

  • Forward contracts
  • Futures contracts
  • Options
  • Warrants
  • Swaps

What Is a Derivative?

Derivatives are an advanced or technical form of investing and are most useful when speculating or hedging.

When used as a hedge, derivatives allow for risks associated with the price of the underlying asset to transfer from party to party. Speculators, however, enter into derivative contracts in order to profit from volatile asset, index, or security prices. These traders will try to buy an asset at a low price on a derivative contract when the market price is high — or sell an asset for a high price when the market value drops (going short).

It is important to remember that while the value of a derivative is based on an asset, you don't own the asset if you own the derivative.

However, the seller does not have to own the asset in order to sell a derivative. She can either give the buyer enough to purchase the asset at the current price or give the buyer a new derivative that offsets the value of the first. In this way, it is far simpler to trade derivatives rather than the asset itself.

Examples of Derivative Contracts

Futures contracts are considered derivatives because their value is influenced by how the underlying contract performs. Likewise, stock options are derivatives because their value is based on the underlying stock's value.

Derivative contracts are based on, but independent from, other contracts. They involve parties who are not associated with the underlying contract.

For instance, a juice packaging plant's contract to buy orange juice from a manufacturer is a derivative contract that is independent from the manufacturer's contract with orange farmers, but the price of juice is tied to the price of oranges.

Likewise, contracts based on a share's price have nothing to do with the purchase of those shares, but their prices are tied.

When Are Derivative Contracts Used?

Derivatives are financial contracts that derive their value from underlying assets. Buyers agree to purchase assets on a certain date, at a certain price.

Traders often use derivative contracts for trading commodities such as gold, gas, or oil. Derivatives are also often used for currencies such as the U.S. dollar. Some derive from stocks or bonds, while others are based on interest rates like the 10-year treasury note yield.

Economic Impact of Derivatives

There are several types of derivatives, and they can be a both a positive or a negative economic force.

These contracts can stabilize the economy. However, given the right conditions, they can completely dismantle an economy. Derivatives make it difficult to identify actual risks, guard against those risks, and predict the domino effect that can bring down networks of institutions, corporations, and organizations all because of one poorly-written or structured derivative.

Most derivatives depend on the person or institution being able to fulfill the conditions of the deal. However, these can quickly go awry if people use loans to enter into these complex deals. As a result, we could see many high-value derivatives that have very little actual cash attached to them. When these deals go bust, \everyone stands to lose big.

Derivatives Trading

Traders exchanged 25 billion derivative contracts in 2016. Thirty-six percent of these were traded in Asia, 34 percent were traded in North America, and Europe traded 20 percent of all derivatives. These contracts were worth a total of $570 trillion—that's six times the world's total economic output in 2016.

Over 90 percent of Fortune 500 companies use derivatives as a tool to lower financial risk. Futures contracts, for example, promise the sale of an asset at an agreed price. This protects the buyer if the price rises, and the seller if the price falls. Derivatives also help guard against changes in currency exchange and interest rates.

These contracts can make cash flows much more predictable. Because companies are able to use derivatives to accurately forecast their earnings, stock prices rise, businesses need less cash-on-hand, and they can use more money to reinvest in their company.

Hedge funds and investors use derivative trading to gain leverage. Derivatives don't require a large down payment; rather you just have to “pay on margin.”

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