A derivative is a financial contract that derives its value from an underlying asset. The buyer agrees to purchase the asset on a specific date at a specific price.
Derivatives are often used for commodities, such as oil, gasoline, or gold. Another asset class is currencies, often the U.S. dollar. There are derivatives based on stocks or bonds. Others use interest rates, such as the yield on the 10-year Treasury note.
The contract's seller doesn't have to own the underlying asset. They can fulfill the contract by giving the buyer enough money to buy the asset at the prevailing price. They can also give the buyer another derivative contract that offsets the value of the first. This makes derivatives much easier to trade than the asset itself.
In 2019, 32 billion derivative contracts were traded.1 Most of the world's 500 largest companies use derivatives to lower risk. For example, a futures contract promises the delivery of raw materials at an agreed-upon price. This way, the company is protected if prices rise. Companies also write contracts to protect themselves from changes in exchange rates and interest rates.
Derivatives make future cash flows more predictable. They allow companies to forecast their earnings more accurately. That predictability boosts stock prices, and businesses then need a lower amount of cash on hand to cover emergencies. That means they can reinvest more into their business.
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