Derivatives are assets that derive value from an underlying instrument, such as a stock, bond or commodity. Hedge funds, sophisticated traders and commodity market participants use derivatives to assume or reduce risk. Derivatives cost less than their underlying assets, and most have an expiration date. Derivatives such as options and futures trade on organized exchanges that enforce rules pertaining to purchase and sale. In many cases, derivative holders can exercise an option to convert a derivative into the underlying security.
The price of a derivative could be based on the value of a stock, a bond, a commodity, mortgages or other assets. Derivative assets are not hard physical assets but contracts that have a defined and limited life. They are traded in world financial markets among buyers and sellers who are betting on the future price of the underlying asset that is represented by the derivative.
Options, a type of derivative asset commonly traded in the stock market, are binding contracts between traders that give one the right to buy or sell shares of a particular stock at a specific price; the other trader has the obligation to buy or sell shares of that stock at a specific price. The option is a derivative of the underlying stock. Options on the stock of Microsoft, for example, are directly influenced by the price of Microsoft stock. The difference is that options expire; you can hold Microsoft stock for years, but the option you purchase to buy shares of Microsoft stock at a specific price expires and becomes worthless at some point in the future. Owning an option does not give you any share of the underlying stock, only the option to trade the derivative asset for a profit.
Futures contracts are legally binding contracts that trade on worldwide financial exchanges. They set the condition for the delivery of commodities such as cattle, pork and soybeans. Buyers and sellers bet on the expected future price of the underlying commodity. Futures contracts are available for more than just commodities; they also cover underlying assets such as bonds, interest-rate products, world currencies and precious metals, such as gold and silver. These derivative assets have a specified life span. The owner does not own the underlying commodity, only a highly leveraged contract that is based on the anticipated future price of the underlying commodity.
Collateralized Debt Obligations
Collateralized debt obligations, or CDOs, were at the heart of the credit crisis of September 2008. A CDO is a derivative asset of real-estate mortgages. A CDO places many mortgages in a single pool and creates bonds that investors buy and sell in the secondary market. At the height of the real-estate boom, some of the derivative assets associated with the U.S. real-estate market were highly leveraged derivatives of derivatives. When home prices began to fall and homeowners with adjustable rate mortgages could not refinance to avoid the higher payments brought on by rising interest rates, they began to default on their mortgages. This caused the derivative assets to either lose significant value or become worthless.