What is a derivative?

Definition and Example of Derivative

Derivatives are financial instruments whose value is derived from the relationship with another underlying asset. This asset is often bonds, stocks, commodities, indices, or currencies. Derivatives can derive value from almost any underlying asset.

How Do Derivatives Work?

Derivatives can be used as speculative tools or for hedging risks. They can help stabilize the economy – or render it incapacitated. One example of derivatives that had a flawed structure and were destructive in nature is mortgage-backed securities (MBS) that led to the sudden housing collapse in 2007 and 2008.

Types of Derivatives

Derivatives can be purchased through a broker as “exchange-traded” contracts or standardized contracts. You can also buy derivatives in the over-the-counter (OTC) market as non-standardized contracts.

Risks of Derivatives

Although derivatives can be beneficial, they carry some risks. Among these risks are lack of transparency, counterparty risk, and leverage. These risks can affect companies, individual investors, and the economy of society as a whole, as seen in the financial crisis of 2007 and 2008.

Source: https://www.thebalancemoney.com/what-is-a-derivative-and-how-do-derivatives-work-358098