What Are Derivatives ?

If you are connected to any kind of financial market or watch the financial news even for 5 minutes every day, it is likely that you have heard the word, financial derivatives many times. The media is flush with articles wherein derivatives are criticized or appreciated. Most of the times, commentators are in awe of the mind-numbingly large amounts behind these contracts.

It is often said that the total amount of derivatives contracts in the worlds, is actually greater than the total amount of money available in the world! How can this happen? Well, to understand this we will have to delve a little deeper into the subject of derivatives. Let’s have a brief introduction of the subject in this article.

Future Date

A derivative contract is essentially a contract. The contract specifies that some future commodity may be exchanged at a later date at a price fixed today. Notice the fact that the agreement would basically be worthless if not for the time difference between the setting of the price and the actual execution of the trade.

Since the price is set today, let’s say at $100 and the transaction takes place a month from now when the price could be any amount greater or lower than $100, the derivative contract becomes valuable. The derivative contract becomes a license to purchase commodities at below market prices and book an immediate gain.

Therefore, the value of the contract is derived from the fluctuation in the price of an underlying asset and hence the term derivatives to define these securities.

Modern day derivatives markets provide a mind-numbingly large number of options to the buyers and sellers of such contracts. One can literally buy a derivative on anything. Obviously assets like stocks, bonds and commodities form the basis of majority of these contracts. However, there are derivatives available for people who would like to predict the amount of rain or sunlight in a given time period at a given place!

Obligation vs. Option

Derivative contracts are characterized by the actual trade taking place at a future date. However, there can two types of contracts. Some contracts are symmetrical. This means that the buyer and seller are both bound to the contract.

In other words, there is an obligation for both of them to go through with the trade. Consider a contract between a farmer and a merchant wherein both of them are obligated to sell and buy (respectively) a farm’s produce.

There are other derivative contracts which are asymmetrical. This means that one party has the right to but not the obligation to follow through with the contract. Consider the above mentioned case. Let’s suppose that a contract is drawn up wherein the farmer has an option to sell the produce to the merchant. This means that the farmer can decide whether or not he wants to follow through with the transaction. The merchant on the other hand is obligated to follow through with the transaction.

It must be noted, that there cannot be a contract wherein both parties hold options. The option must be held by only one party. If both parties hold options, then there isn’t a contract at all because no decision has been made!

Time Restriction

Since derivatives are contracts, they have an expiration date. This means that after a certain date they become completely worthless. Hence they must be utilized within a given time period or else they do not hold any value. This is opposed to the general notion of financial assets. Financial assets like stocks and bonds usually hold value for a much larger period of time. Derivatives on the other hand hold value for an extremely short period of time and this is their defining feature.

Settlement

Theoretically speaking, derivative contracts can be settled in both cash as well as kind. This means that the person executing the contract has the right to ask for delivery of the underlying commodity or the amount of money which is equivalent to the underlying commodity.

However, in reality derivative contracts are usually always settled in cash. Asking for delivery of the underlying commodity is an unheard of occurrence in the modern world.

High Leverage

The derivatives contracts are characterized by extremely large leverage ratios. Leverage ratios of 25 to 1 and 33 to 1 are common while trading derivatives. This is not a defining feature of derivatives meaning that a contract cannot be called a derivative contract just because it is highly leveraged. However, this is the norm with most derivative transactions.

Zero Sum Game

Derivative contracts are a zero sum game. This means that the parties in a derivative contract are directly betting against each other. If one party wins, the other party by definition has to lose. This is opposed to the stock market when a rising stock price can be beneficial for everyone who is holding that stock. The fact that derivatives carry a high leverage and are a zero sum game meaning that one of the parties involved has to lose makes it an extremely dangerous financial instrument.

Controversy: Systemic Risk

Derivatives are extremely infamous. Traditional and conservative investors like Warren Buffet call them “weapons of mass destruction”. This is because derivatives build in a systemic risk. A small number of firms can build up an extremely large interest in certain securities. This means that failure of these firms can bring the system crashing. To add to this, these parties have extensive financial relationships with one another. Therefore, an adverse event at one organization can lead to a cascading effect and a chain of adverse events bringing the entire system to a halt. This is precisely what happened after the Lehman Bank collapse in 2008 and this is the reason why there is increasing clamor that the derivative market cannot be left on its own and needs to be tightly regulated.