What is a Derivative in Finance?

Financial Derivative If you’re beginning to learn about different types of investments, eventually you’ll to know what a derivative in finance is. A derivative is a kind of financial security that’s derived from some other asset, such as a stock or commodity. The term derivative may sound complicated, and in calculus, the definition of a derivative is somewhat more complicated than it is in finance. A derivative based on a financial asset, however, is straightforward.

How Derivatives in Finance Work

If you buy a derivative, you essentially get a contract to buy some amount of financial assets for a predetermined price. Whether the market value of the asset goes up or down, you pay the agreed-upon price at the end of the contract period. Derivatives are often used by owners of commodities to ensure that they make at least a minimum profit from the goods they own. For example, a farmer may sell a contract to buy soybeans for a set price after they’re harvested to make sure he earns the money he needs to keep his business going. This kind of derivative is called a future, because it’s based on the future value of a product.

When futures are bought and sold, only one party in the transaction makes a profit, in contrast to other types of securities, such as stocks, that can provide earnings on both sides of a transaction. Other kinds of futures that are commonly sold include oil, agricultural commodities and shares of stocks. In the winter, futures contracts on orange juice prices are heavily speculated upon by traders trying to make money from crop-devastating winter freezes. Other crops have also attracted heavy speculation in the past, such as cotton crops in the 19th century. The reason only one party profits from the sale of futures is that the contract can’t be sold again when the price of the commodity returns to a favorable level. As a result, many speculators have lost fortunes betting on crop prices, according to Investopedia.

Types of Derivatives

Aside from futures, there are many other types of derivatives commonly traded over the counter or in derivative exchanges. Options are a common type of derivative that are equal in value to shares of stock in a company. Owners of options have the right to buy assets at a specified price within a set time frame, but they don’t have to do it if they don’t want to. A typical example of options are shares of a company offered to employees when they’re hired. They may have several years to take advantage of the offer, or they may have an unlimited amount of time.

The terms of an options contract allows employees to buy shares of a company at a predetermined rate that is usually below the market value of the shares. Normally, an options contract itself costs money, but it’s often included as an incentive for hiring good workers. When traded in financial markets, derivatives must be handled by licensed brokers, but many options and futures contracts are considered over-the-counter trades that don’t require a broker.

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The temptation to wager money on future market prices is too great for many speculators to resist, and large sums of money are gained and lost in derivatives markets. For a change of pace from conventional stocks and bonds trading, you may want to put your money on derivatives in finance and diversify your portfolio.