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Derivatives – What Are They, And What Are They Used For?

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.


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