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What are Derivatives?

written by: Jason C. Chavis•edited by: Rebecca Scudder•updated: 6/29/2011

Derivatives are a financial instrument with an underlying value. Examples of these can include futures, forwards, options and swaps.

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    What are derivatives? Financial instruments with prices derived from an underlying value are known as derivatives. The definition of derivative types means that some component of the value is determined by the price of assets or the value of an index. Examples of these include prices on commodities, stocks, loans, bonds, mortgages and real estate. The underlying value can also be derived from interest and exchange rates, the consumer price index or stock market indices. A derivative calculator can be used to help identify the correct value of these assets.

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    Types of Derivatives

    Derivatives are divided into four main categories: forwards, futures, options and swaps. Forwards are a two-party agreement to purchase or sell a financial instrument for a guaranteed price at a future time. Futures are an agreement to buy or sell at a certain future time at the market price at that time. Options are similar to forwards in that the price is agreed upon at the time the agreement is made, however, the buyer has the right to choose to purchase the asset. Swaps are an agreement to exchange certain cash flows.

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    Uses of Derivatives

    Price risk for an underlying asset is transferred from one party to another, allowing an investor to hedge against that risk. This can occur both ways, for both parties. For example, a corn grower and a distributor can make an agreement to purchase the corn for a specific price in the future. This means that the farmer can guarantee that price when the corn is sold regardless of the market. In addition, the distributor can ensure that he or she will get a fair market price regardless of the size of the crop's yield.

    Speculative investors also find derivatives a good way to acquire risk. This occurs when one party in the contract believes that the other party will be wrong about the value at the time of the sale. This is best leveraged when the speculator can purchase the product at a lower price that the market high. However, this also means that the speculator can end up buying the asset for a higher value than the product is actually worth, taking a loss.

    The recent banking crisis and economic recession was attributed banks, brokerages, and other Wall Street firms creating and selling derivatives which were much riskier than anyone thought. Major ratings firms such as Moodys, Standard and Poors (S&P), and Fitch gave these securities AAA ratings. However, they became the toxic assets that weighed down the balance sheets of multiple financial firms and helped contribute to the failures of Lehman Brothers and the government bailout of AIG.

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    Valuation of Derivatives

    Determining the valuation of a derivative is essential to finding the best possible pricing. The most common way to do this is to determine the market price. This is simply the price which other traders are willing to buy or sell the product. This fact is essentially transparent when dealing in exchange-traded derivatives, however, when dealing with over-the-counter contracts, there is no official way to determine prices. In these situations, a variety of formulas can be used. The most common valuation technique for these situations is the Black-Scholes formula.

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