Derivatives Explained

So I was slightly confused on the first day of class when we discussed all the different financial contracts especially when it came to derivatives, so I decided to read up on it and try to understand it:

The Wikipedia defines derivatives as: Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else (known as the underlying). The underlying on which a derivative is based can be an asset (e.g., commodities, equities (stocks), residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer price index (CPI) — see inflation derivatives), or other items (e.g., weather conditions, or other derivatives).

There are three main types of derivatives, known as forwards or futures, options and swaps. Derivatives are used mainly in two ways, called hedging and speculation. During Hedging, these derivatives are used to reduce the risk of loss when the value of these underlying assets change. During Speculation, these derivatives may be used by investors to increase their profits if the value of the underlying assets change the way that they expected.

I found a good example on usafutures.com that shows a great example of how a soybean farmer uses future contracts to hedge against falling crop prices to reduce the risk of his economic loss.

According to the Washington Post, Pres. Obama sent out a proposal in June 2008 to reduce the speculation in the energy market. This proposal will attempt to increase federal oversight in these markets and also prohibit international trading in unregulated futures markets. As a result, soaring oil prices may be stabilized . It seems that if speculation is not regulated it can be used in a negative and unethical way. In contrast to this, several airline companies use hedging in oil prices to reduce their daily running costs.

Hope this helps, made things a little clearer for me...