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If you’ve dabbled in investments or have an interest in markets, it’s likely the term “derivative” has been thrown around. It’s a term that money managers use on many occasions, and financial publications across the world used it to describe the 2008-09 financial crisis. Those who don’t understand the term, however, are typically on the outside looking in, not sure what to make of derivatives or how they affect them.

What Is It?

A derivative can be defined as a contract or security whose value comes from its relationship to another underlying asset or set of assets. The common underlying assets include bonds, commodities, currencies, stocks and interest rates. They are popular in business, where large companies and individuals such as Othman Louanjli take a professional interest in them because they are more flexible than the underlying assets.

Derivatives exist in many forms. They can be bad or good and can be used for productive results or speculative reasons. At a large scale, derivatives can bring stability to an economy or do more harm than good, as highlighted by the financial crisis. When the parties involved in derivatives fail to identify the risks and institute proper safeguards against them, bad things can happen.

Early on, derivatives were important for ensuring balanced exchange rates for goods traded between international parties. Since different currencies have different values, international traders needed a way to account for these differences. Derivatives provided that and over the years have gained many more uses.

Depending on the type of derivative, there are a number of functions and applications in place for their use. There are derivatives used for hedging, which essentially means to insure an asset against risk. Derivatives can also be used for speculative reasons, such as betting on the future price of a commodity. For example, a European investor looking to purchase stock of an American company at an American exchange while using the United States dollar would be exposed to exchange rate risks if he/she were to hold on to that stock. To protect themselves against this risk, the investor could buy currency futures to trade the stock at a specified future date based on a specified exchange rate.

Another example would be the commodity derivatives used by millers and farmers to provide some measure of insurance. The farmer agrees to the contract to lock in a good price for the product, while the miller agrees to the contract to lock in a guaranteed supply. Although both parties have reduced their risks through hedging, they are both exposed to the risk of price change due to various reasons, including a shortage of harvest due to bad weather. In such an event, the farmer loses out on the additional income that could have been earned. If the price of the product drops, the miller could have to pay more for the commodity than they would have wanted.

Common Forms

  • Futures contract. The futures contract explained through the farmer and miller example is one of the most common forms of derivatives. Also known as futures, they are a contract between two parties for the sale of a commodity or asset at a price agreed upon by the two.
  • Forward contract. A forward contract is another form of derivative. While it is similar to a futures contract, the big difference is that it is traded over the counter and not through an exchange.
  • A swap is a contract between two parties to exchange a financial instrument for another.
  • An options contract is an agreement between two parties that gives the purchaser the opportunity to sell or buy an asset at a predetermined future date.

In the business world, derivatives make it easy to predict future cash flows for companies, allowing them to forecast earnings. That predictability improves stock prices and also helps businesses invest more in their operations.