Many people are blaming the explosive, unregulated derivatives market as one of the main causes to the current credit freeze. So I’m sure many Americans, including me, are wondering: “What’s a derivative?”
When I think of the term derivative, I think of mathematics. I believe that security derivatives do have something to do with math, but in reality, according to Wikipedia’s page on derivatives, a financial derivative is an agreement - a right to buy or sell a security (i.e. stock, asset, or debt) at a certain price. Even though derivatives aren’t “real” investments themselves, they are definitely traded.
That still doesn’t make much sense to me, but from what I understand the purpose of a derivative is to lower risk for one of the parties involved in the agreement and / or potential transaction. But the risk is still there, right? And if I understand correctly, the risk of the actual security holder is compounded through the use of derivatives. Maybe not, but I’m fairly certain that the original risk of the security is not diluted.
Anyone more familiar with derivatives care to chime in here and shed some light on the matter?
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