What Are Derivatives?

Introduction

A derivative is a financial contract whose value is derived from an underlying asset — a stock, commodity, index, or currency. Derivatives are powerful tools for hedging and speculation, but they carry significant risk.

The Underlying Asset

The value of a derivative depends on an underlying asset. Examples:

• A stock
• A commodity (oil, gold)
• A market index
• A currency or interest rate

Common Derivatives

• Futures — contracts to buy/sell at a set price on a future date
• Options — rights to buy/sell at a set price
• Swaps — exchanging cash flows (often used by institutions)

Why Use Derivatives?

1. Hedging — protecting against adverse price moves (e.g., a farmer locking in crop prices) 2. Speculation — betting on price direction 3. Leverage — controlling a large position with a small amount of capital

The Big Risk

Derivatives often involve leverage, which magnifies both gains and losses. A small price move against you can wipe out far more than you invested. Derivatives are complex and best left to experienced investors.

Small capital  ->  big exposure (leverage)
Price against you  ->  magnified loss (possible margin call)

Real-World Example

An airline buys oil futures to lock in fuel prices — hedging. A trader uses leveraged options to speculate on a stock price. The airline manages risk; the trader accepts risk.

Summary

• Derivatives derive value from an underlying asset
• Used for hedging, speculation, and leverage
• Leverage magnifies both gains and losses
• High complexity and risk — not for beginners
• Underlyings: stocks, commodities, indices, currencies

Next Lesson

One major derivative in detail: futures contracts.