Loans and money issues

A derivative (also known as a contingent claim) is an investment whose value is itself determined by the value of some other underlying base asset. For example, a bet that a Van Gogh painting—the base asset—will sell for more than $1 million is an example of a contingent claim, because the bet’s payoffs are derived from the value of the Van Gogh painting (the underlying base asset). Similarly, a contract that states that you will make a cash payment to me that is equal to the square of the price per barrel of oil in 2010 is a contingent claim, because it depends on the price of the underlying base asset, oil. As with other financial contracts, we believe that both parties engage in derivatives contracts because it makes them better off ex-ante. For example, your car insurance is a contingent claim that depends on the value of your car (the base asset). Having the insurance is valuable only if the underlying base asset has been involved in an unfortunate accident. Ex-ante, both the insurance company and you are better off contracting to this contingent claim than you would be without the insurance contract. Ex-post, more than likely, only one of you will come out better off.