You might have heard others talk about derivatives. What are derivatives and how do they work? Derivatives are one of the most important financial innovations in history, but they are often misunderstood.
They are securities whose value is determined by or derived from other underlying assets like shares, land among others.
Derivatives can help stabilise the economy or bring the economic system to its knees in a catastrophic implosion due to an inability to identify the real risks, properly protect against them, and anticipate so-called “daisy-chain” events where interconnected corporations, institutions, and organizations find themselves instantaneously bankrupted as a result of a poorly written or structured derivative position with another firm that failed; a domino effect.
Most derivatives are based upon the person or institution on the other side of the trade being able to live up to the deal that was struck.