A derivative is a financial instrument that can be traded
either on or off of the stock market. They can be used in options trading and
can be used to exchange a floating rate of return for a fixed rate of return.
In very simple terms, a derivative is measuring the rate at which something
changes in comparison to something else.
Derivatives involve the trading of rights or obligations
based on the underlying product but do not directly transfer property. They are
used to hedge risk or exchange a floating rate of return for a fixed rate of
return.”
A derivative can be looked at as a payoff with one or more
underlying variables. The payoff can be now or at some time in the future, and
the underlying variable can be related to such things as stock prices and
indexes, bond prices and interest rates, foreign currency exchange rates,
commodity prices, as well as events that cannot be controlled such as earthquakes
and hurricanes.
Even though many people are not able to understand what
derivatives are, or how they work, they are quite simply explained by using
events and occurrences that everyone is familiar with. For example, the way
that the social security system works can be considered a derivative. Social
security is a system that requires employed individuals to make a series of
payments to the government over a period of time. After reaching a
predetermined age, the payer can receive a payoff, based on many factors such
as how much they paid into social security, how old they are, and how long they
live. In this case, the derivative is a security, whose payoff depends on many
underlying variables. Disaster insurance is also a derivative, wherein a
homeowner may purchase flood insurance at a set price over a specified amount
of time, in return for a potentially higher payoff in the event that a flood
occurs and damages their property. The underlying variable here would be of
course, the flood, and the security would be the insurance premiums paid out by
the homeowner.
The underlying variable, in some instances, can also be
looked at as an underlying asset. Examples of underlying assets can be a
financial asset such as a government bond, a commodity such as gold or silver,
or an index such as the S & P.
A financial instrument or contract must contain a number of
components if it is to be considered a derivative; it must have an underlying
variable that is somehow attached to a payment provision, and it must have a
notional amount. A notional amount is a number of specified units, such as
shares, pounds, bushels, and etc. that are named within the text of the
contract. Without one of these two components, a financial instrument cannot be
considered a derivative. Understanding how a derivative works, and what it is,
is very important in today’s society.
Disclaimer:
This article is presented solely as an example and is not meant to replace qualified
financial advice. If you or someone you know require up to date financial or
legal help please seek qualified assistance. No content on this site should
ever be used as a substitute for direct legal advice from your lawyer or a qualified
attorney.
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