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What Is a Derivative?

An Explanation of Derivatives and How They Work

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One of the most common words thrown around on the news and Wall Street today is “derivative”. With very few exceptions, virtually no one stops to explain to new investors precisely what a derivative is or how one works. In the next few moments, you’re going to learn everything you wanted to know about derivatives and, perhaps, even be able to impress your friends at your next cocktail party.

The Definition of a Derivative

The short answer: A derivative is anything that is valued based upon some other asset. In other words, it derives its value from something else.

The long answer: A call option, which is a simple type of stock option that gives the buyer the right (but not the obligation) to buy 100 shares of a certain stock at a pre-determined price, is a derivative because the value of the option depends on what the underlying stock does. In the case of GE stock options, for instance, whether the stock option makes money, loses money, or breaks even depends entirely upon what General Electric shares do. Thus, the options “derive” their value from GE stock. They are a derivative.

Farmers in the heartland are responsible for a lot of derivatives in the United States. They often want to lock in a price for their crops in order to protect their harvest and calculate the profits they’ll make each season. They work with special brokers or companies to sell futures contracts on commodities exchanges. These contracts allow them to sell crops they haven’t yet grown or which are not yet ready for harvest at a predetermined price. The value of these contracts (what the farmer gets paid) depends on what the underlying commodity does over the period of the futures contract. Again, whether a futures contract makes money, loses money, or breaks even depends entirely on the price of the commodity to which it is tied. A coffee futures contract, for instance, “derives” its value from the price of coffee beans.

The Different Types of Derivatives

Derivatives are used banks to protect themselves from interest rates changes. As we already discussed, farmers use them extensively (even if they don’t realize it because they are working with a big company such as Cargill). Employees in startups that are paid with stock options own derivatives. Some insurance contracts are structured as derivatives to protect lenders in case their loans go bad. Energy companies use futures to lock in oil prices when they think they are high to protect the company. Airlines use futures to lock in oil when it's low, such as Southwest Airlines did, allowing it to pay $10 per barrel long after the cost of oil had risen to $100+ per barrel. There are even weather derivatives to protect certain types of businesses from hurricanes.

Why Are Derivatives Dangerous

Although derivatives can help make the economy function by reducing risk for farmers, oil companies, startup employees, and more, left unchecked, they can introduce “systematic risk”. Only a handful of firms represent a massive portion of the total derivatives traded in the world meaning that if one of them went bankrupt, it could lead to a daisy-chain effect that caused all of the others to fail, wiping out the entire financial system.

The failure of Lehman Brothers nearly caused this to happen during the Credit Crisis and would have succeeded had it not been for the extraordinary intervention by the Federal Reserve, Treasury, FDIC, and other government agencies.

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