What are Financial Derivatives?

John Sunshine

A derivative is a financial instrument that gets its value from some real good or stock. It is, in its most basic form, simply a contract between two parties to exchange value based on the action of a real good or service. Typically, the seller receives money in exchange for an agreement to purchase or sell some good or service at some specified future date.

Businessman with a briefcase
Businessman with a briefcase

The largest appeal of these instruments is that they offer some degree of leverage. Leverage is a financial term that refers to the multiplication that happens when a small amount of money is used to control an item of much larger value. A mortgage is the most common form of leverage: for a small amount of money and taking on the obligation of a mortgage, a person gains control of a property of much larger value than the small amount of money that has exchanged hands.

Derivatives offer the same sort of leverage or multiplication as a mortgage. For a small amount of money, the investor can control a much larger value of company stock than would be possible without use of these instruments. This can work both ways, though. If the investor is correct, then more money can be made than if the investment had been made directly into the company itself. The losses are multiplied instead, however, if the investor is wrong.

This type of financial instrument made the news in 1995 when rogue trader Nick Leeson single-handedly caused the failure of the Barings bank of England. Nick Leeson was a derivatives trader whose trades did not work out and, due to the enormous leverage of the trades used, the losses became so large that the bank went bankrupt. Warren Buffett, a much revered and very successful investor, has stated in one of his annual reports that he is very much against the use of these instruments, and he expects that they will lead to eventual failure for anyone who uses them. In spite of all this negative press, however, they have long been a normal part of business and investing and are likely to be so for many more years.

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Discussion Comments

anon157952

When were derivatives first used?

anon153796

It was informative.

anon153794

leasing sounds similar to derivatives. Is that right?

anon152723

i would like to know why derivatives can introduced?

anon151620

i am a MBA student. i want to know both financial derivatives and commodity derivatives.

anon150104

i want full details about financial derivatives.

anon121935

i am MBA student and i would like to know whether financial derivatives would be helpful for management students.

anon90676

I want to learn more about derivatives.

anon79870

i want to know about the financial derivatives.

elnaz6367

can you clarify financial derivatives more for me?

anon69745

i want to know about commodity derivatives and financial derivatives.

anon66037

I am M. com student and don't know about derivatives. i want to increase my knowledge with your help. Please send me more information about finance marketing, derivatives, capital markets and share markets.

anon39678

define synthetic futures.

anon39062

what is the use of financial derivative in capital market?

anon30191

Can we use financial derivatives as a investment option?

anuchirayath

i would like to know whether the financial derivatives are really value enhancing...... and how can we evaluate the market efficiency of the financial derivatives... what are the tools/techniques used here?

anon11480

Bear Stearns anyone?

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