What Are Derivatives

What are derivatives? Many beginning investors are not clear on what derivatives are, as they have to do with speculation and future performance of a certain market. However, once you can answer the question, "What are derivatives?" you can be on your way to getting a good return on your investment. Examples of derivatives are futures, contracts, swaps, forwards and others.

A derivative is essentially a binding contract for a person to buy or sell an asset at some point in the future, but the person is paying for it in the present. Its value is "derived" from the value of something else. In order to lock in the contract, the investor must provide some kind of cash somewhat immediately for the right to do business a certain way in the future. In essence, it is the right of one group to buy or sell from another party at a locked in price.

One example of how a derivative works is using the example of the Japanese rice farmers and the rice warehouse merchants. A rice farmer could sign a contract with a merchant in the spring that would allow the merchant to pay the farmer a set amount of cash. In exchange for the immediate cash, the rice farmer would deliver a certain amount of rice after the harvest. The rice farmer has lowered the business risk because he has received a certain price for the rice, while the merchant has locked in the price for a certain amount. However, the wisdom in the exchange will be decided at harvesttime, especially if there is a shortage or overabundance of rice.

Derivatives are important in the world of finance because they allow for hedging and managing risk. They are one of the fastest growing segments in the financial market. However, since derivatives have no value themselves and are dependent on the value of another asset, there is a larger risk associated with them. While they can lead to quick profits, derivatives are best taken up by those who can understand the relationships between product volume, price trends and consumer interest.

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