An Introduction to the World of Derivatives

A quick walk through the latest playground of high finance

The first question one might have is what is a derivative. For all of you who are now remembering their high school and college mathematics, you're wrong. It's not that kind of derivative. Actually the name derivative comes about because the actual contract (i.e. a derivative contract) "derives" its value from some underlying asset, for example stocks, bonds or commodities. There are four main types of derivatives; futures, forwards, options, and swaps. The parties that enter into a derivatives contract are called counterparties.

An example

The main idea of a derivative is to reduce risk for one party. The classic example which is given in may 1950s textbooks on economics is that of the miller (Adam Smith would be proud). The miller buys a large quantity of wheat and intends to grind it into flour. The process of milling might takes days or even weeks during which time the price of wheat might go up or down dramatically. He might either make a windfall profit or suffer a huge loss that could lead to bankruptcy. What is the poor miller to do? Never fear help is on the way and they come as economists. The miller can protect himself with help of a futures contract one form of a derivative.

The mechanics of this futures contract is quite simple. When the miller buys his (or her) wheat for immediate physical delivery using cash, he (or she) also sold the same quantity of wheat short for future delivery at that days price. The contract would settle at about the time the finished product (made from the wheat just purchased) would be leaving the mill. The miller pockets the proceeds of the futures contract sale immediately. The miller now only has to;

  1. deliver the real product and
  2. fulfill the short contract.

If the price of wheat goes up by the time the miller delivers his (or her) the wheat in the mill would rise in value, but the miller would have to pay more than when he entered his (or her) short contract to cover the contract. The gain and loss would cancel each other out. Conversely if the price of wheat goes down, the wheat in the mill is worth less, but the miller would recoup the loss when he (or she) buys wheat to cover the futures contract. In this case the miller would again break even.

Textbooks stress that the speculators (the financial gamblers are called counterparties because the financial community doesn't like the word gambler) in these futures contracts deals perform a socially useful role by accepting risk in the hope of obtaining a profit.

The financial community loves to use examples like this and similar ones to describe the role of derivatives and the useful function they play in society.

The reality

Now let's see what Rick Bookstaber has to say about this description of derivatives. [ 1 ]

"In academic theory, derivatives and swaps are intended to help "span the state space"; that is, they are intended to allow investors to efficiently hedge their specific risks, to more precisely meet contingencies of the market, and to mold their returns to meet investment objectives.

In practice, however, swaps and derivatives are often used for less lofty purposes. They are used to: avoid taxes (for example, total return swaps are used to take positions in UK stocks in order to avoid transactions-based taxes); take exposures that are not permitted in a particular investment charter (for example, index amortizing swaps were used by insurance companies to take mortgage risk); speculate (for example, the main use of CDSs is to allow traders to take short positions on corporate bonds); lever beyond an allowed level; and take risk off-balance sheet, where it is not as readily observed and monitored.

The more complex swaps and derivatives not only find ready demand by serving these functions, there are strong profit incentives for the investment banks to supply them. The more complex the instrument, the greater the chance the investment bank can price it to make profit, for the simple reason that investors will not be able to readily determine its fair value. And if they create a product that is exclusive to them, they can also charge a higher spread when an investor wants to trade out of it."

You may ask what some of these complex derivative products might look like, as well you should. Well here are some examples; [ 2 ]

Dorothy, we have come a long way from wheat in Kansas.

The low down

Now here is the really good part about derivatives. The financial industry has been fighting to keep derivatives trades unregulated and 'off book" (and winning to date). While traders who buy and sell futures contracts for pork bellies in Chicago operate under the watchful eye of the Commodity Futures Trading Commission (CFTC) banks, hedge funds and corporations can gamble without anyone knowing.

Unfortunately the financial industry casino culture has a very sick addiction to gambling huge sums of money on derivatives which tend to distract them form the job their institution is supposed to be doing, say making loans to individuals and businesses in the case of banks.

The growth in derivative trades has been explosive and has some rather strange bedfellows as you can see from this derivative timeline. If you took a look at the timeline you found that credit derivatives have gone from practical nonexistence in the 1990's to between $20 trillion (million million) to $34 trillion in 2006 this according to the British Bankers association (again remember the derivatives market is unregulated and off book so it is difficult to obtain accurate numbers).

[ 1 ] My "non-testimony" on the regulation of swaps and derivatives

[ 2 ] Surviving the Cataclysm, Webster G. Tarpley