A derivative is a financial instrument like an option and or futures contract whose value is derived partly from the value of another security, which is the underlying security. In layman’s terms, a derivative is a bet as to whether the value of the underlying security, which might be a stock, bond, or financial index, will increase or decrease by a specified date.
Derivatives are typically used to protect asset prices and things like inventories or potential future purchases. In reality, derivatives are a generic term for a wide class of financial products. Some of these products, like futures contracts and options, are well-defined and enjoy a relatively widespread understanding. On the other hand, there are classes of derivatives that are poorly understood. These derivatives are usually not traded publicly, but are individual contracts between firms to buy and sell products, or insure against loss or give a firm the right to buy a product in the future a set price.
These non-traded derivatives can be classified as exotic in nature. Exotic meaning they are each unique to a finite situation that exists between two parties. Many of these exotic derivatives are poorly understood by both the public and the government.
Futures contracts are traded on regulated exchanges and there is a high degree of transparency in their daily trading activity. Futures contracts have been around for more than a century, and early derivatives date back to Japanese rice trading in the 1600s, meaning futures trading is well understood and heavily traded.
You might be surprised at the wide range of commodities, metals, financial indexes, and a host of other unusual futures contracts that can be traded. For example, there are futures contracts on energy products, meats and a host of other contracts. Generally these contracts are used to lock-in prices for producers of the products or the investors of the products listed. Futures allow a producer to lock-in a price so a firm can produce and price their product with the future in mind.
It’s important to understand that well-regulated futures provide a valuable service to industry. On the other hand, exotic derivatives have, at times, resulted in extraordinary losses.