How do derivatives work?

Fsp Invest, 04 Dec. 2013

Tags: derivative, derivatives, how do derivatives work, why are derivatives dangerous, why derivatives are dangerous, derivative instrument, what is a derivative

Derivatives are some of the most commonly traded instruments out there.
The words ‘derivative instruments’ are common turn of phrase on Wall Street…
But nobody ever stops to explain what they really are.
So for new investors who don’t know the ropes yet, derivatives may seem daunting at first.
Today, you’re going to learn everything you’ll ever need to know about what derivatives are and how they work.

A definition of what a derivative is
A derivative is anything that gets its value from another, underlying asset. 
In other words, it derives its value from something else!
Hence, it’s called a ‘derivative’!
And the basis of its value can be almost anything you can imagine, from the weather to the credit rating of a particular company. 
So, because of their versatility, you can use them for a number of different things. 
You can use a derivative product if you want to avoid the risk of a particular event occurring. 
Say, you are worried about the price of corn falling. 
You can then buy a derivative instrument whose price will go up if the price of corn goes down!
That way you hedge your risk. 
And on the other side of the risk equation, speculators try to make money by predicting how the market will move. 
So a speculator might bet that the US dollar will lose value, and buy a derivative whose value will go up if it does!
Why derivatives are dangerous
Although derivatives can help an economy remain healthy by getting rid of risks for the likes of farmers and oil producers…
Because only a select few companies trade them, if one of them folds, it could drag the whole economy down with it.  
In fact, trading in credit derivatives was one of the things that made the folding of Lehman Brothers such a disaster for the world economy!

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