Derivatives are financial products that were originally developed as way for investors to hedge their bets on securities. These derivatives take many forms, but most have two or more parties taking opposing positions on various assets. Both parties assume a certain amount of risk that offsets the other parties' risk. Most trading for derivatives occurs over the counter, as there is no centralized market for most types of these products.
A derivative is a kind of contract in which one party agrees to pay another party a certain amount of money in the event that certain events take place. For example, in a basic derivative -- an interest rate swap -- one party will agree to pay another party money if the interest rate falls below a certain figure. This swap can be sold as a hedge, or the other party will agree to pay money in the event the rate moves above a certain level.
Derivatives can take many forms, and can involve many different parties, and an almost infinite number of variations. Therefore, most derivatives are not sold on exchanges, but are sold between investors over the counter. This means that the derivatives market has substantially less regulation than other markets, making it relatively risky for investors.
One of the main risks of trading derivatives is that it can be extremely difficult to accurately value them. This is because the value of a derivative will usually be contingent upon the changes in the price of an asset that have not yet occurred. To accurately value a derivative, you have to be able to guess how the asset to which it is linked will change value in the future.
Because many derivatives involve significant counterparty risk, holders can often have significant financial exposure, particularly if an asset changes value in a way that is entirely unexpected. For example, assume a derivative was linked to an interest rate, with one party agreeing to cover another party if the interest rate rose. If the interest rate rose significantly, the other party could face catastrophic financial losses.
- "Economics"; Roger A. Arnold; 2009
- "Investing For Dummies"; Eric Tyson; 2008
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