What are Financial Derivatives?

Check out my latest video where I explore the cool world of Financial Derivatives…

VIDEO SUMMARY

This video is on financial derivatives. I am going to outline the basics you need to know to understand financial derivatives. This is a very cool subject area, so let’s get started with some basics.

A financial derivative is a contract that derives its value from an underlying asset. When you purchase a financial derivative, you are not purchasing an asset. You are purchasing a piece of paper that derives its value from another asset. This is a very important distinction to understand. So for instance, if you wanted to participate in the oil market, but you did not want to actually go out and purchase barrels of oil, you could purchase a financial derivative instead. You would be purchasing a piece of paper instead of the barrels of oil. This could be preferable for all sorts of practical reasons. But it’s this idea that I want to emphasize. When you purchase a financial derivative, you are purchasing a piece of paper, not the actual asset. That’s not to say the paper is not valuable, the value is based on an asset you don’t own.

To put this in context, in Finance, there are three broad categories of financial instruments: 1) stocks 2) bonds 3) financial derivatives. We have already talked about stocks and bonds. Now you might say that owning a stock in a company is just like purchasing a piece of paper like the stock certificate. But it’s not really. When you buy a stock, you are actually buying a piece of a company. You actually own that asset. Now in contrast, if you bought an option, which is a financial derivative, you would be buying a piece of paper that is related in value to the stock price, but you would not actually own any of the company. The same is true with bonds. When you buy a bond, you are actually buying a piece of a person’s credit worthiness. The difference is subtle, but it is there. Financial derivatives are a piece of paper that derive its value from an underlying asset.

To understand financial derivatives, you need to understand a little bit of history. Financial derivatives started with farming. Now farming is an interesting business model. When you have a farm, you put in all the investment at the beginning of the season when you plant the crops. You make all your profit at the end of the season when you harvest the crops and sell them to the market. Now a lot can happen in between when you plant and when you harvest. Notably, commodity prices can change. If you spend any time watching commodity markets, you know prices fluctuate up and down with supply and demand, sometimes quite dramatically. So here you are as a farmer at the beginning of the season, trying to make a decision whether to plant corn or soy beans. That is a business decision. It is a very difficult decision about something you have no control over, commodity prices. And part of that decision is based on what you think the prices will be at the end of the season. But you really don’t know. Now finance people are smart and came up with a brilliant answer. “Let’s create a complex financial derivative.” So they wrote a legal contract. This legal contract guarantees a set price to purchase the crops at the end of the season. This helps out the farmer in making his decision, because he knows what his profit is going to be. Of course, it will cost the farmer a little something to set this up, but it is worth it to mitigate the risk of changes in commodity prices. Here’s the really brilliant part. Once the contract is created, the piece of paper suddenly has value, because anyone holding the contract can make the transaction. So it creates a financial market for these pieces of paper that can be bought and sold between parties. Because what happens, is as the commodity markets change prices, the value of this piece of paper changes as well. So if the price for corn or soy beans goes up, above the price specified in the contract, whoever holds the piece of paper will make an instant profit. They can buy the crops and then instantly sell them on the market for a higher price. So this market of financial derivatives gets created.

Financial derivatives seem to always get bad press. You sometimes will read news stories about someone losing a lot of money in financial derivatives. It’s important to keep in mind, they are just like any other financial instrument, and it’s possible to lose money. But I think a lot of people don’t understand how financial derivatives work. And I think a lot of the haters don’t really understand how large the financial derivatives market is, or how much value it creates for the world. So in the next video, I am going to walk through a number of financial derivatives and explain how they create value.

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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.