In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest binary option indicator for sale, and is often simply called the “underlying. This section does not cite any sources. From the economic point of view, financial derivatives are cash flows, that are conditioned stochastically and discounted to present value.
The market risk inherent in the underlying asset is attached to the financial derivative through contractual agreements and hence can be traded separately. The underlying asset does not have to be acquired. Derivatives are more common in the modern era, but their origins trace back several centuries. One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century. Derivatives may broadly be categorized as “lock” or “option” products. Frank Wall Street Reform and Consumer Protection Act of 2010. However, these are “notional” values, and some economists say that this value greatly exaggerates the market value and the true credit risk faced by the parties involved.
Still, even these scaled down figures represent huge amounts of money. 5 trillion, and the total current value of the U. It was this type of derivative that investment magnate Warren Buffett referred to in his famous 2002 speech in which he warned against “financial weapons of mass destruction”. For example, an equity swap allows an investor to receive steady payments, e. LIBOR rate, while avoiding paying capital gains tax and keeping the stock. For arbitraging purpose, allowing a riskless profit by simultaneously entering into transactions into two or more markets. Lock products are theoretically valued at zero at the time of execution and thus do not typically require an up-front exchange between the parties.
One common form of option product familiar to many consumers is insurance for homes and automobiles. Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. The individual or institution has access to the asset for a specified amount of time, and can then sell it in the future at a specified price according to the futures contract. Derivatives trading of this kind may serve the financial interests of certain particular businesses. For example, a corporation borrows a large sum of money at a specific interest rate. The interest rate on the loan reprices every six months.