Derivatives in Layman’s Language

What is Derivatives in Layman’s Language?

All of you MUST have heard the “Derivatives” several times in Media Channels & Newspapers. In fact, the current USA Economic crisis is because of the Derivative Products. Once Warren Buffet, The Legendary Investor told in his Company’s Annual Shareholders’ letter that, “Derivatives are the weapons of the mass Financial Destruction.”

So What it means by Derivatives?

Well, Derivatives are something which derive their value from something else mainly the underlying Basic Asset Class.

Say for Example, Orange Juice is the Derivative of the Orange. Understand?

Now, Stocks (Shares) are the Derivatives of the underlying Company/Business. Mutual Funds are the Derivatives of the Stocks. Previously, Money was the Derivative of Gold but now it is the Derivative of Debt.

Let us discuss one example. Suppose, Your Friend wants Rs.100 and you lend him Rs.100 at the interest rate of 10% per year. So Now you give your friend Rs.100 Bill and your friend gives you on paper written ‘Promise’ that he will pay you the original amount as well as the Interest rate.

This Promissory Note is known as a ‘Derivative’. It is the first power Derivative.

Now let us discuss the other Scenario. Your friend needs Rs.100 but you don’t have Rs.100 to lend him so you go with your parents and borrow Rs.100 from your parents at the rate of 5% per year and give them a Promissory Note & after that you lend this Rs.100 to your friend at the rate of 10% to your friend.

So at the end of year, you will earn Rs.10 interest from your friend, you give Rs.5 interest to your parents and keep Rs.5 with you. This is known as Third power Derivative. Because here you make money out of an idea only.

Banks & Financial Institutions do the same thing but on very large scale. When you Deposit your money in the Bank, The bank will lend this money to other Borrowers at the rate of 10-20% per year and Bank gives you 4% interest on your Savings Account. At the end of the year, the Bank will earn money from the spread margin of the Interest rate.

Derivatives are like Double Edged Sword, Means if used properly, they can make you extremely Rich but at the same time, they have potential to make you Very poor, Broke or even Bankrupt….!!!