What are Derivatives?

What are derivatives?  Simply put, derivatives are insurance that helps  a person minimize his or her risk in an investment.  For example, if I was a potato farmer and I wanted to protect my earnings for the next year, I could purchase a derivative.  Let us say I want to ensure that I get a least $15.00 for each bushel of potatoes. Since it is hard to predict the future, I do not know what will happen on the market.  I visit a derivatives broker firm, purchase a derivative, and enter into an agreement with the buying party or the investor.  No matter what happens, I will still get my $15 a bushel for my potatoes.

The investor then takes the bushel of potatoes that he paid me the $15 for and puts them on the open market for $25 a bushel.  He makes $10 from each bushel.  This is a good thing when things are going good.  However, what if something happens in the market that lowers the price of the potato?  The investor must still give me the $15 in any case.  However, most of the time the investors have a stop-loss clause agreement with their brokers.  This helps to minimize the financial loss to a certain percentage.

Like I was saying before, this is excellent when things are going great. However, derivatives must be monitored and regulated or things can get out of hand quickly with disastrous consequences.  If people are not doing what they should be doing, the this process can affect the US Economy in a negative way.  It is easy to see how a few ripples in the derivatives market can cause an economic tsunami in the United States.