If you know anything about the 2008 Financial crisis or have seen the movie “The big short” then you most likely have heard the word “derivative”
But what is a derivative?✅
Derivatives are a security, a contract -- that derives its value from its relationship with another asset or stream of cash flows. There are many types of derivatives and they can be good or bad.
Most derivatives are based on the person or institution on the other side of the trade being able to live up to the deal that was struck. Most derivatives require the counter-party to put up collateral or capital and the risk of the counter-party not living up to their deal is called counter-party risk.
Examples of derivatives could be:
Employee Stock Options:🤵🏻
Granted as part of the compensation for working for a company, employee stock options are a type of derivative that allows the employee to buy the stock at a specified price before a certain deadline. This means employees could get a discount on a stock which may be rising or has the potential to rise.
This essentially obligate the buyer to buy an asset and the seller to sell an asset at a predetermined price.
Example: Imagine you own a farm. You grow a lot of corn. You need to be able to estimate your total cost structure, profit, and risk. You can go to the futures market and sell a contract to deliver your corn, on a certain date and a pre-agreed upon price. The other party can buy that futures contract and, in many cases, require you to physically deliver the corn.
Companies, banks, financial institutions, and other organizations routinely enter into derivative contracts known as interest rate swaps or currency swaps. These are meant to reduce risk. They can effectively turn fixed-rate debt into floating rate debt or vice versa. They can reduce the chance of a major currency move making it much harder to pay off a debt in another country's currency. smart!