Business

Derivatives

A financial derivative is a financial instrument, the value of which is based on the value or values of one or more underlying assets or indexes of assets. Derivatives can be based on equities (stocks), debt (bonds, bills, and notes), currencies, and even indexes of these various things, such as the Dow Jones Industrial Average. Derivatives can be sold and traded either on a regulated exchange, such as the Chicago Board of Trade, or off the exchanges, directly between the different counterparties, which is known as "over-the-counter'' (OTC).

A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. Derivatives are contracts and can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region. Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes.

We live in a world where commodity prices can increase dramatically and then collapse, property prices can reach vertiginous levels and uncertainty is prevalent in all facets of economic life. But if we look more closely at this dynamic economic picture "risks" are not equally shared or perceived: for an airline company rising oil prices mean increased costs and the risk of reduced profits; for an investor looking for higher returns than a treasury bond, investment in oil is rewarded with high returns. Although for both parties the future is equally uncertain, each party has different exposure to the same set of future scenarios.

One can therefore see a role for a financial institution that offers to protect a party...