Derivatives (financial)

Derivatives (financial), financial instrument whose value is based on an underlying asset. For example, futures contracts, also called futures, are a derivative. Futures are contracts to buy or sell commodities. The commodities are assets that have real value, while the futures derive their value from the commodities they are based on.

Another type of derivative is the stock option. Stock options give an investor the right to buy or sell shares of a certain stock at a specific price. The value of the option rises and falls with the price of the stock, the underlying asset. There are many other, more complex derivatives. Some are based on international currencies, some on changes in interest rates, others on combinations of several underlying assets.

Derivatives allow investors to hedge when buying a certain asset. Hedging is a way to protect against a loss in value of an investment. For example, if the holder of a certain stock is concerned that the stock price will fall, he or she might purchase a type of option whose value will increase if the stock falls in price. The option thus provides a kind of insurance against loss for the stockholder.

Derivatives are useful as tools for hedging. However, when used for speculative investing—that is, buying investments in hopes of selling them quickly for a profit—they hold a great deal of risk. Derivatives have a great amount of leverage. In other words, an investor can control assets worth far more than the original investment. As a result, an investor can also gain profits or incur losses larger than the investment. Derivatives received wide publicity in 1994 when the treasurer of Orange County, California, drove the county into bankruptcy by trading unsuccessfully in derivatives.