Financial derivatives are a category of securities that include futures, options, forwards and swaps. Basically, derivatives are an agreement between an investor and another party that will be paid out when a certain asset reaches a certain level. That definition might seem vague, but only because derivatives are a very broad category of security [source: Rutledge]. In a futures contract, the investor agrees to buy an asset at a given price on a certain date. An option is similar, only the purchase is optional. A swap is when two parties exchange an asset, often to obtain a preferential interest rate [source: Rutledge].
Derivatives have become controversial because economists have linked the 2008 credit crisis to failures in the derivatives market [source: Summers]. However, derivatives are often used as a way to decrease risk in an investment portfolio. For example, a fund manager might use foreign currency futures to offset potential losses in investments made in a foreign country, or use an interest rate swap to take advantage of changes in interest rates [source: Rutledge]. Some derivatives (like options and futures) are relatively accessible for individual investors. Others (like many swaps) are usually only traded by large institutional investors.
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