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Q: What’s a derivative?

A: It’s a financial contract whose value is “derived” from another security, such as a stock, bond, commodity, currency, or a market index such as the S&P 500.

Some common types of derivatives are options, futures and mortgage-backed securities.

They’re sometimes used to “hedge” risk, such as when companies limit their exposure to losses from currency-exchange rate fluctuations or fuel-price volatility.

Some derivatives can be very risky, such as when they’re used to amplify gains (and losses). Warren Buffett has called derivatives “time bombs” and “financial weapons of mass destruction.”

The Motley Fool