A financial derivative is an agreement to set the price of an investment based on the value of another asset. For example, when you purchase currency futures based on a specific exchange rate, the value of the futures will change as that currency’s exchange rate changes.
The concept of financial derivatives is not commonly used by the general public. They are typically used by large investors to manage risk. There are two key concepts about financial derivatives:
- They help create leverage, so that an object can be related in terms of other values and you can minimize risk.
- They are used to either take on more risk or reduce risk, depending on what kind of contractual agreement is made.
The concept of a financial derivative can be difficult to understand, so looking at some examples may help.
Examples of Financial Derivatives
The contractual setup between an investment asset and a share of stock or currency is characteristic of the concept of financial derivatives. The price of both should move in tandem, directly related to the increase or decrease in value of the financial derivative.
Derivatives are things that cannot stand alone in terms of value - the value is directly related to something else in the economy. For example these investment assets are commonly used as financial derivatives:
- Currency rates
- Interest rates
- Market indexes
With the underlying value of an asset is established, it is almost impossible to conceive of how much that asset is worth without an understanding of the value of the asset to which it is dependent as a derivative. You can think of what the face value of an object could be, but its true value would be determined using complicated mathematical formulas to separate the asset’s value from the asset.
Terms Related to Financial Derivatives
There is a lot of financial jargon and terms to learn in order to understand financial derivatives. Here are some tips to help you understand the terms:
- Consider the kind of relationship between the underlying investment asset and the derivative. Relationships could be a "forward," "swaps" or "options."
- Consider what kind of market the underlying investment and the derivative trade in. They could be exchanged in a trade in the stock market, or they might be traded person-to-person or “over the counter.”