What Are Financial Derivatives?

Financial derivatives are scary, right? I mean, that's what the media says about financial derivatives: that they are so scary and so hard to understand that they won't even bother explaining financial derivatives to you.

What would you say if I told you that you use financial derivatives every time you drive a car?

Financial derivatives are a little like a car insurance. You pay a little bit of month, or year, along with millions of other drivers. Now, the underlying value of that contract you have with the insurance company is worth thousands if you would damage your car. If you were in a wreck, you probably wouldn't have built up thousands of dollars yet in your account to cover those costs, so the money to repair that damage would be pulled from the money other drivers and the insurance companies ability to invest that money.

But, you say, there are HUNDREDS OF TRILLIONS of dollars in financial derivatives. True. But, if my car insurance analogy holds, there are tens of millions of cars, and the insurance contracts are worth tens of thousands of dollars, so there are trillions of dollars in those financial derivatives, as well.

Now, where there are problems is when it comes to the handling of risks. Let's say the government tells your insurance company that you have to insure drunk drivers who constantly use the cell phone. Well, your risk just went way up and there's an increased chance that there will be so many wrecks that the insurance company won't have enough money from all the monthly fees and all the invested assets to cover the cost of repairing those vehicles.

In other words, the financial derivatives went toxic.

And, that's a very simplistic way to explain the fear over financial derivatives. The financial derivatives are just a tool and, if used and traded correctly, they are amazing tools that decrease risk and let more people do things like drive cars and own homes. Once the underlying risk of the financial derivative is changed... then there are problems.

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