That is, their performance depends on how other financial instruments perform. Derivatives serve a valuable purpose in providing a means of managing financial risk. By using derivatives, companies and individuals can transfer any undesired risk to other parties who either have risks that offset or want to assume that risk, for a price.
Although derivatives have been around in some form for centuries, their growth has accelerated rapidly during the last 25 years. They are now widely used by corporations, financial institutions, professional investors and individuals. Certain types of derivatives are actively traded in public markets, similar to the stock exchanges with which you are probably already familiar. The vast majority of derivatives, however, are created in private transactions. Just as a corporation may buy land for the purpose of ultimately setting-up a factory, or engage in a derivatives transaction.In neither case is the existence or amount of the transaction easy for outsiders to determine.
This chapter welcomes you to the world of derivatives and provides an introduction to some financial concepts that you will help you understand derivatives better. Let us begin by exploring the derivatives markets more closely and defining what we mean by these types of instruments.