It may sound like a house of cards, but many financial instruments in the global economy are based on nothing more than the value of other financial instruments. This scares many investors, and derivatives are often blamed for many of the excesses in the world economy. In fact, derivatives are not necessarily any riskier than any other investment in the global marketplace-they just have to be properly understood.
A derivatives, as its name implies, “derives” its value from another item of value. A financial future, for example, is an agreement to buy financial instrument, such as a stock price then goes up- or if interest rates move dramatically, affecting the prices of the underlying bonds- a financial future can skyrocket or plummet precipitously.
Many investors primarily those looking for a quick profit without carefully analysing the risks involved, have been burned by the explosion of derivative trading on the international markets. California’s Orange County, for example, became insolvent during 1990s after investing heavily in interest rate –linked precipitously.
Some derivatives can actually allow investors to avoid risk, giving them the possibility to “hedge” otherwise risky position. A retired homeowner, for example, may use an investment in interest-rate derivatives to counterbalance the effect of inflation on the value of the home.