Complex financial instruments have been an innovation in the market efficiency in capital markets. They can help reduce risk, limit exposure to changing prices, but also can be highly lethal, when it comes to bringing down financial empires. eg. CDO’s from the USA, were traded, and they turned into toxic assets.
Warren Buffet the legendary investor, the Sage of Omaha, the CEO of Berkshire Hathaway, and one of the world’s richest men, is quoted to refer to derivatives as financial weapons of mass destruction.

So what are derivatives ?

To put is simply, they come from agriculture, when farmers hundreds of years ago want to secure the price of their harvest crop (rice, corn, wheat etc etc) in the future, to protect them against market changes, such as over production or perhaps another unforeseen problem like a drought. In the financial world, they are exactly the same, derivatives are contracts whose value is “derived” from the price of something else, typically a share (stock), and a share is an equity instrument, so an equity derivative, for example, might give you the right to buy BT Shares (BT plc) at a stated price up to a given date. And in these circumstances the value of that right will be directly related to the price of the “underlying” BT Share: if the share price of BT moves up (which can only be a good thing…especially if you are in sharesave…..) then the right to buy BT shares at a fixed price becomes more valuable; if it BT shares then moves down (which upsets me and fellow shareholders), the right to buy BT shares at a fixed price becomes less valuable.

A good example from the FT, as explaining them which a physical asset, shoes !! Here is the example.

Say you believe the price of Gucci shoes is going to rise in 30 days’ time. You want exposure to that price rise. To speculate, you buy those Gucci shoes on Ebay at today’s price for delivery in 30 days. No matter what happens to the price of Gucci shoes in the interim, you are scheduled to receive your shoes in 30 days’ time for the price you paid today. If the price of the shoes shoots up in the interim, there is nothing stopping you from selling them on to someone else for a higher price. On delivery date, you would simply sign over the right to the delivery to the person you sold the shoes to.
In some cases, the seller of the Gucci shoes (if she believes the price is going to fall) might even be inclined to sell the right to those shoes in 30 days’ time, before actually obtaining them first herself. That is because she believes they may become cheaper closer to delivery time. No matter how many times the contract exchanges hands, in 30 days one pair of Gucci shoes has to be delivered by the seller to the ultimate recipient. Not a pair of Clarks loafers. Not a pair of Nike trainers. Only a pair of Gucci shoes of a certain specification will do. On delivery day, then, the price of the futures contract has to converge with the underlying supply and demand fundamentals of Gucci shoes.

To put it very crudely, it is like a piece of insurance, to protect against price movement.