Learn about derivatives with iMinds Money's insightful fast-knowledge series. In economics, a derivative is defined as a financial instrument or an “agreement” between two parties that is based on an “underlying” and generally tangible asset, such as a stock or a commodity.
For example, during the process of purchase there is a financial exchange for what is essentially a material benefit or instrument. Therefore, a derivative merely “derives” its value from this underlying asset which is of true material value. Financial investors use derivatives as a means of leverage in what is known as the derivative market. An example of a common form of derivative is that of a customer who walks into a store and purchases a cigar in exchange for money. In this case, the exchange is complete and both parties hold tangible items.
However, if the customer had phoned the dealer in advance, requesting the cigar be held for two hours until he/ she arrived and the retailer agrees, then a derivative is created. The agreement is simply derived from a proposed exchange, that they will trade money for cigar in two hours, not now.
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Does financial jargon such as "hedging", "derivative", and "commodity" make your head spin? If so, take a listen to iMinds' series of very brief introductions to these important concepts. In less than 10 minutes, and using plain language spoken simply by Emily Sophie Knapp, iMinds gives the listener clear answers to most basic questions.
In this instalment, "derivatives", or financial "agreement[s]...based on an underlying and generally tangible asset", are helpfully compared to a cigar that one party agrees to purchase from another party at a later point in time.
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