Finance Explained: Derivatives

I’ve wanted to do some short explanations of financial terms for a while now, mostly as a reaction to the way people keep talking about them without any idea of what they actually are or mean. This first one is about derivatives. If you have any requests for other financial terms I could explain, please send me a message and I’ll see what I can do.

Hello my name’s chris hemmings and i want to do a couple of videos looking at different financial terms and to just explain a little bits of it i really want to do derivatives because ever since the financial crisis which which was maybe two or three years ago now a lot of people have have been banding around these financial terms without actually knowing what they

Are and particularly derivatives have got a huge fourth part of the blame actually put onto them so i really want to explain what a derivative is just so people know so the definition in a nutshell is a derivative is an asset whose price depends on the price of something else whether that’s something else be you know wheat or or slinkys you know or something in

Between the two so now i’m going to you know and there are there are hundreds and there are thousands of derivatives that you can use so i’m just going to concentrate on on one and there’s one derivative called a call option now imagine you sell bananas and you have you have to import them from somewhere in south america and a box of bananas to last you a month may

Costs let’s just say it costs 50 or 60 pounds you know the price changes because there were differences in the yields of the crops that we changes in the currency so the price of that box will will change over the year you know and even if you run the business for a couple of years that’s going to change it might be as low as 40 pounds it might go to 70 pounds now

Let’s say that there is a big disaster in the place when you get your bananas wrong and that pushes the price of the box at the nhanes up to 200 pounds now you have a couple of options here you can either buy the box in which case you have to sell the bananas at a hugely inflated price no one’s gonna buy them you’re gonna go out of business the alternative is that

You don’t buy the bananas and you go out of business anyway now this is where the derivative comes in you can actually buy something which says that if the price goes above say 80 pounds you only pay 80 pounds if the box is 40 pounds you pay 40 pounds and 70 pounds pay 70 pounds but if it goes up to 100 pounds to 200 pounds you only pay 80 pounds and so that’s

And that means that if the price does jump hugely if there is a if there was an earthquake or a disaster you can still buy that box of bananas and you can still carry on trading now that seems you know obviously you can’t just have that is going to have a price in a sense it’s it used it’s used as insurance for obvious reasons so the price of that derivative is

Based on the probability that the price of the box bananas will go above 80 pounds and also by how far above 80 pounds it’s likely to go so for example if it could only go up to 90 pounds then the derivative might cost 2 pounds you know so the price went to 90 pounds then or 100 pounds you would paid in total 82 pounds and which is manageable you you you know that

You can spend that so it is a way you know and there are lots of different kinds of derivatives so maybe it will take the average of the price of the box bananas over the month and that’s what you pay yeah and it’s called an option because you can decide not to buy the boxed 80 pounds which is as i’ve said if it’s 40 pounds you can still pay 40 pounds for it so

That’s why derivatives were invented they were invented as a form of insurance and they still continue to do that function they are very valuable things they are very useful but obviously over time they’ve become more and more complicated and people who understand how they work have sold them to people who don’t understand how they and obviously that’s caused a

Lot of problems anyway so hopefully you know what a derivative is now and at some point i may go into hedge funds or hedge funds you and i might go into short selling and if you have any requests for other financial terms that i could explain please let me know thank you very much for watching and you look forward to seeing you again very soon

Transcribed from video
Finance Explained: Derivatives By Christopher Hemmens