What are financial derivatives?

by Girl Banker
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The very word "derivative" makes some people start running for the hills. It sounds scary, complicated, brain numbing. However, if you take the time to read a little about them, the majority of derivatives are easy to understand, particularly derivatives that are designed to hedge specific financial risks. Speculative derivatives can get a lot more complicated.

A derivative is a financial product whose value depends on the change in the value of some other underlying product. 

Derivatives are primarily used for:

• Hedging: to protect a company against an adverse move in the market price of an input (costs) or an output (prices). To Become an Investment Banker focuses on explaining hedging. It's an important concept to understand because a lot of big companies undertake hedging activities.
  
  
• Speculation: to benefit from an expected change in market prices.
  
  
• Arbitrage: to take advantage of a perceived mispricing(s) in the market.
  
  

Understanding derivatives will a) help you decide what sort of products you might enjoy covering and b) it will give you a better feel for some of the key concerns that companies have to consider. 

In the equity capital markets, the simplest derivative is an equity call option and in the debt capital markets the simplest derivative is an interest rate swap. So read:

What is LIBOR? (it's an important variable in derivatives pricing)
What is an interest rate swap (or IRS)?  
What is a call option or an equity call option?

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