Derivatives

Financial Dictionary -> Investing -> Derivatives

In finance Derivatives are financial instruments that are only representations, with their value being based on the market value of another underlying asset such as stocks, bonds or other commodities. An example of a derivative is a futures contract, options and forward contracts among others.

To take the futures contract (which is a document that grants the right to a financial transaction in the future based on the current market price) as an example, the value of that contract is not in itself, but derives from a fluctuating market place.

Bob takes out an oil futures contract where in 5 years he has the right to buy 6 barrels of oil at $5 million. The value of his contract is based on the underlying asset of oil, which has a constantly changing value. We all know how prices at the pumps fluctuate. If the price of oil skyrockets the futures contract also goes up in value because Bob can then buy his oil at the old market price and make a killing when he sells the oil on.

This process of utilizing the value fluctuations of the underlying asset to profit from financial instruments like futures contracts is known as hedging, but carries a great amount of risk. Although it may seem like a weight of each other's minds for the two parties that are buying and selling oil; they both know that in the future they will make a deal based on today's economy, they do not know what the future brings and there may be no oil left at the time, or the value of it may be dramatically different, making the transaction impossible to go ahead. The possibility of large losses on either side of the fence causes great criticism of derivatives, although some people are obviously successful else they wouldn't exist.