DERIVATIVES.....
WHAT ARE THEY?

a picture of a derivative equation

Derivative: A financial instrument whose value is derived from an underlying asset

Derivatives. We have all heard the term. What does it mean?

As stated above a derivative is any instrument whose value is determined by an underlying asset. The product thus "derives" its value in accordance with some formula which includes the value of that basic asset. In his book Options and Option trading, Robert Ward uses the analogy of children and parents to describe derivatives. Just as children derive many of their characteristics from their parents, yet remain quite different in many ways, so too do derivatives gain their value from the underlying asset.

Beginning in the mid 90's the term derivative began to take on a negative connotation. For the most part, this was related to a couple of high profile situations in which entities arranged derivative contracts without fully understanding their implications, and thus suffered large losses. One of the most prominent of these situations was in Orange County California where the treasurer, Robert Citron, borrowed $14 billion in 1991 and invested that money in derivative contracts with Merril Lynch. It wasn't until the Federal Reserve began to raise interest rates in 1994 that the county government began to suffer huge losses and was unable to meet its obligations. Regardless of the value of derivatives, from that time forward they were viewed with suspicion, though the typical individual likely cannot even explain the nature of the product.

Bonds, Stocks and Commodities comprise the basic markets. These are known as "spot" markets. The term spot simply implies a market in which goods are sold for cash and can be delivered immediately. Options, Futures, and Forwards are markets in which transactions occur on forward markets. This means simply that the contract between buyer and seller allows for a transaction to be completed at some date in the future. Once initiated, a transaction in these markets is often completed at a date weeks or months hence.

Why Even have Derivates if they are so risky?

There is a purpose in the derivative contract. It undoubtedly can facilitate trade. It does this, by allowing the risk related to an underlying asset to be transferred from one individual to another. The explanation below is taken from our leverage section:

The first futures markets in the United States sprung up in the midwest. The Chicago Board of Trade notes its foundation as April 3, 1848, with the then governor William H. Bissell signing and approving a special charter for the Board of trade of the City of Chicago 11 years later. It was no surprise that this Board of Trade picked Chicago as its home, with the primary trading instruments being commodities, of which grains and livestock composed a large proportion. Chicago was central to many farming states and the great lakes provided the necessary transportation.

Farming has always been tricky business. It is not enough that grain farmers have to deal with soil conditions, insects, drought and the like, but they also have to decide how much to plant, which requires predicting demand. This is a difficult, if not impossible task. In the early 1800's a farmer may well plant, protect, and harvest his crop with expertise, only to find that when he transported it to the marketplace a glut had caused the price to fall to unprofitable levels. This lesson might then be learned all to well, causing few farmers to plant grain the following year and leading to severe deficits. The only prices available for farm products at the time were prices for same day delivery. What was a farmer to do?

The advent of the Futures markets allowed for farmers to plan. A forward contract could be arranged between the producer and consumer, thus specifiying an agreed upon price and date for future delivery. The contracts were tailor made to fit the needs of the two specific parties involved. Commodity involved, size of the order, and date of delivery were all negotiable. This worked well.....unless it didn't work. If price were to change significantly, either the producer or consumer would simply fail to abide by their contract. There had to be a better solution. With that in mind, came the formation of the Chicago Board of Trade.

The formation of the CBOT led to changes. No longer would the consumer and producer decide on specifics such as instrument and quantity and date of delivery. Contracts would be specified by the CBOT. In addition, initially the CBOT, and later Clearinghouses, would be responsible for contract settlements. Individuals who agreed to forward contracts would thus be bound by them.

Transferring risk from one party to another is an important aspect in the facilitation of trade. It is one of the things that separates advanced economies from less well developed ones. The facilitation of trade is an enormously important aspect of increasing GDP, which is in the best interests of all, leading to economic growth that enhances the lives of everyone.

With this in mind, it is clear that derivates are not an evil product, but simply a product that may or may not be used. The important aspect of derivatives trading is in understanding clearly and precisely what risk will be transferred and how. Just as a bank wishes to transfer intrest rate risk to the buyer of an adjustable rate mortgage, a derivative product may accomplish a similar goal through other means.

Though the above example with farming prices marks the beginning of derivative use in the United States, these products have advanced far beyond that simple state and that is where some of the confusion lies. Historically, there are countless examples of situations in which the buyer of a derivate product lost much more than anticipated as the contract matured. The primary reason has been a lack of understanding of the terms of the risk transfer involved.

An example of derivative use in the business world today is with interest rate risk. Interest rate Swaps, Forward rate agreements, caps, etc. all involve one party being willing to accept interest rate risk and another party making the effort to transfer that risk, at a price. Banks use this type of derivative contract regularly. Currency risk too is often delegated to another party at a cost, in order that global businesses may plan accordingly. Of course, credit default swaps and mortgage derivatives have been in the news for the last four years since all of the major U.S. brokerage firms suffered such huge losses in the mortgage market debacle. It is important to remember that some investment strategies may allow for certain types of risk exposure moreso than others. Segregating this risk with derivatives, and allowing for it to be divided among differing parties may benefit all involved.

The important thing to remember is that derivatives are not in and of themselves inappropriate or evil. They have been used in unethical ways many times in the past, and most importantly marketed in an unethical manner such that the seller would make effort to conceal his reasons for utilizing the product, and the true risk involved to the buyer. This was clearly so in the mortgage fiasco with Goldman Sachs and other brokers. But without derivatives contracts businesses would not be able to hedge risk as needed and production and trade would suffer.

Some common derivatives: