What are Derivatives? A Simple Explanation for Kids and Beginners

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Introduction to Derivatives for Kids and Teens

This video explains the concept of derivatives in a simple, concise way for kids and beginners. It could be used by kids & teens to learn about derivatives, or used as a money & personal finance resource by parents and teachers as part of a Financial Literacy course or K-12 curriculum.

Suitable for students from grade levels:

• Kindergarten
• Elementary School
• Middle School
• High School

The topics covered are:

• What are Derivatives
• Different kinds of derivatives
• A real-world example
• Why are they used
• How does derivatives trading work
• Should you invest in derivative instruments

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What are derivatives?

Derivatives are complex financial instruments that have value only because they are connected to something else, called the underlying asset. In other words, derivatives derive their value from the underlying instrument which could be stocks, bonds, currencies, interest rates, commodities, etc.

On their own, derivatives have no value. The price of the derivative is determined and influenced by the price of the underlying asset.

Are there different types of derivatives?

Yes, the most common derivatives are futures, forwards, swaps and options.

At a high level, futures, forwards and swaps are binding on the holder of the contract – which means the parties that enter into the agreement must fulfill their obligation. Options, as the name suggests, give the option holder the right, but not the obligation, to buy or sell the underlying instrument.

We cover each derivative instrument in detail in separate videos.

Humm… That’s complicated! Can you explain it with an example?

Let’s say Ben, a corn farmer, is worried that the price of corn will go down by the time his crop is ready for harvesting and wants to lock in the sale price at the current market price.

On the other hand, Sam, a popcorn manufacturer, thinks that corn prices will go up in a few months and wants to lock his purchase price at the current market price.

In this case, Ben and Sam enter into a forward contract, which is an agreement for Ben to sell and Sam to buy a fixed amount of corn at a future date, say 3 months from now, at today’s price. This way, they both hedged their risk based on their assessment of the future corn price.

Why are derivatives used?

Derivatives were primarily created for hedging risk, like we discussed in the example.

However, derivatives are highly leveraged instruments where the parties can trade by putting up only a small percentage of the trade value upfront, called the margin. This makes them high risk, high reward investments, and are therefore used by risk seekers for speculation.

How does derivatives trading work? And how can I invest in derivatives?

Some Derivatives are traded on exchanges, just like stocks. These can be bought and sold through your regular brokerage account if you have enrolled for derivatives investment.

But most derivatives are traded directly between two parties, usually financial institutions like banks, with the contract terms mutually agreed between the two parties. These are called Over-the-Counter, or OTC derivatives.

Should I invest in derivative instruments?

Derivatives provide leverage, which results in an amplified effect on your returns: both profits and losses can be huge. In order to invest successfully, a deep understanding of the instruments, the markets and the risks involved is a must.

Therefore, derivatives are best left to seasoned investors, and should be avoided by new or inexperienced investors.

Conclusion

What do you think about derivatives? Have you invested in any? Please let us know through your comments below!

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Download Transcript: Ideal for Use by Teachers in their Lesson Plan to Teach Kids & Teens

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Podcast: What are Derivatives