Key to understanding this rationale and a point that is crucial to introduce early on is the notion of a premium. Some derivatives are compared to insurance. Just as you pay an insurance company a premium in order to obtain some protection against a specific event, there are derivative products that have a payoff contingent upon the occurrence of some event for which you must pay a premium in advance. A derivative financial product is a contrived instrument, the value of which depends indirectly on the price of a cash instrument. Examples of cash instruments include actual shares in a company, physical stocks of commodities, cash foreign exchange, etc.
Derivatives exist to solve specific positioning, accounting and regulatory problems.
These reasons may not be immediately clear to you but they will be after you read all of the derivatives articles on this web site. It is mandatory for financial institutions to report their financial accounts in this fashion. Another aspect of financial derivatives is the fact that they are carried off-balance sheet, generally. When we speak of the size of a particular derivative contract, we refer to the notional amount. The notional amount is the amount used to calculate the payoff.