What Are Derivatives?

Have you ever locked in a price for a future purchase, like agreeing on a rental price months before your trip? Or maybe you've seen airlines hedge fuel costs to avoid unexpected price spikes. These are real-life examples of the concept behind derivatives: financial contracts whose value depends on something else, called the "underlying asset."


A derivative is a financial contract between two parties. Its value is tied to the performance of an underlying asset, which could be a stock, commodity, currency, or even an interest rate. Instead of directly buying or selling the asset, derivatives allow you to bet on its future price or protect yourself from risks.

Real-Life Examples of Derivatives in Action

  • Farmers and Crop Prices: Imagine you’re a farmer growing wheat. You’re worried that wheat prices might drop by the time your crop is ready for sale. To protect yourself, you enter into a contract with a buyer today, agreeing to sell your wheat at a fixed price when it’s harvested. This contract is a futures contract, a type of derivative, and it shields you from price uncertainty.

  • Travelers and Currency Rates: Suppose you’re planning a vacation abroad in six months. You’re concerned that the exchange rate might change, making your trip more expensive. By entering into a currency forward contract, you can lock in today’s exchange rate, ensuring you know exactly how much you’ll spend.

  • Airlines and Fuel Costs: Airlines use options to hedge against rising fuel prices. For example, they might buy a contract giving them the right (but not the obligation) to purchase fuel at a fixed price. If prices go up, they exercise the contract and save money. If prices go down, they simply buy fuel at the lower market price.

Why Are Derivatives Useful?

  • Risk Management (Hedging): Derivatives help businesses and individuals protect themselves from unexpected price changes. For example, farmers use futures contracts to guard against falling crop prices, and airlines hedge fuel costs to stabilize expenses.

  • Speculation: Investors use derivatives to bet on the future direction of prices without owning the underlying asset. For instance, a trader might speculate that oil prices will rise and profit from a derivative tied to oil.

  • Access and Flexibility: Derivatives provide exposure to assets that might otherwise be difficult or expensive to trade directly. For example, an investor can use derivatives to gain exposure to gold without physically owning it.

Our Quantitative Finance course is coming soon!

If you're eager to dive deeper into growing your assets, sign up for our newsletter! You'll receive updates whenever we share valuable insights or content tailored to your interests.

* indicates required