Derivative (finance)

A derivative is a special kind of financial contract. It is a legal agreement between a buyer and a seller.

This contract does not focus on an item people own right now. Instead, it focuses on something that will happen later. Every derivative must have four specific parts to work. There is an item called the "underlier" that will be traded. There is also a future act, like a sale or a purchase. The contract must set a specific price for that trade. Finally, the contract must name a future date for the act to happen.

How these contracts work depends on the type of deal. Some are called "lock" products, such as futures or swaps. These force both people to follow the terms of the deal. Other deals are called "option" products. These give a buyer the right to make a deal, but they do not have to.

An option buyer usually pays a fee upfront for this choice. This is similar to how people pay for car insurance. If the event they want to avoid does not happen, they simply let the option expire. The value of these contracts changes as the price of the underlier moves.

People use derivatives for many different reasons in the world. Some people use them to "hedge," which is a way to manage risk.

For example, a wheat farmer might use a contract to lock in a price. This protects the farmer if the price of wheat falls later. Other people use derivatives for "speculation." This is like making a financial bet to try to earn a profit. They hope the price moves in a way that makes them money. Some people even use them to trade things that are hard to reach, like weather patterns.

These types of deals have a very long history. One of the oldest stories comes from ancient Greece. A philosopher named Thales is thought to have made a profit from a contract about olives.

Much later, rice futures were traded at the Dojima Rice Exchange starting in the eighteenth century. Today, these markets are incredibly large. In 2011, the market for deals made privately was about $700 trillion. Deals traded on official exchanges totaled another $83 trillion. These numbers are much larger than the total wealth of the whole world.

Derivatives are one of the three main ways people trade value. The other two ways are called equity, like stocks, and debt, like bonds.

Because these deals can be risky, governments sometimes make new rules for them. In the United States, the Dodd-Frank Act of 2010 was created to change how they are managed. This happened after the financial crisis of 2008. Some leaders, like Warren Buffett, have even called certain types of these deals "financial weapons of mass destruction." It is a complex part of how the modern world handles money.