July 2, 2010

What IS a Derivative Anyway?

During the real estate crash and the downfall of AIG and other major financial firms we heard a lot about derivatives.  I for one wasn't really familiar with the term derivative and I didn't have a clear understanding of  exactly what it meant. 

The definition of a financial derivative at Wikipedia starts out with : "In financial terms, a derivative is a financial instrument - or more simply, an agreement between two people or two parties - that has a value determined by the price of something else (called the underlying) It is a financial contract with a value linked to the expected future price movements of the asset it is linked to - such as a share or a currency.."

Boiled down to the basics: 
A derivative is a financial agreement between two parties based on future price movements of an underlying asset.

To elaborate that means that two parties agree that they will (or might) buy, sell or trade something  based on future price of the asset.

Further down the page Wikipedia we see that they describe  3 major categories of derivatives:  futures, options and swaps.   Futures and options are fairly common terms and you might have heard of those.   Futures are a contract to sell a commodity or asset at some future date at a price fixed today.    Options are the right, but not the obligation,  to buy or sell an asset.    A swap is a transaction that I'm not really familiar with.   The idea of a swap is an agreement between two parties to swap one cash flow for another.

There are also various underlying assets that you might make a derivative about.   Derivatives are commonly designed to trade on equities, interest, credit, currencies and commodities.

Commodity futures are contracts to buy/sell a commodity at a specific price at a future date.   For example if I'm a corn farmer then I might want to sell commodity futures to lock in a guaranteed price for my corn when harvest occurs.  On the other hand if I'm a popcorn producer producer then I might want to buy a future at a fixed price to lock in that price as well.  So the corn farmer might sell the future and the popcorn maker might buy the future.  

Stock options are contracts to sell the right to buy/sell a stock at a specific price in the future.  Individuals may buy or sell options to hedge against risk in the stock market or to make speculative gambles on how they think an equity might go up or down.

The big difference between futures and options are that futures are an obligation and options are a right.  If you buy/sell a futures contract then you're obligated to buy/sell the asset at a specific future time but if you buy /sell an option then you are not obligated but have the right to buy/sell if you choose to.

Swaps are an agreement to exchange one thing for another thing.   Simple example is an interest rate swaps which might be used between two parties to trade a fixed rate for a variable rate.

There are a number of reasons different parties might engage in derivatives contracts.   In many ways derivatives are used as a form of insurance where one party trades gives money for some risk or vice versa.    Derivatives are used to speculate as betting if a commodity will go up or down.   Companies can use derivatives to exchange interest rates or currency positions.

Weather is even traded as a derivative.   There are situations where two parties could have equal and opposite risks.  Say you've got a farmer and a baseball team in the same town.   If there is a lot of rain then the farmer might prosper but if theres a drought then the farmer will lose money.  On the other hand if it rains a lot the baseball team will lose money and they'll make more money if there are a lot of sunny days.   These two parties have opposite risks and could benefit from trading some of that risk between one another.  They might strike up a contract that says if there is a drought the baseball team will pay the farmer $1000 but if there is a lot of rain then the farmer will pay the baseball team $1000.   This way the farmer reduces his risk that he'll get wiped out by drought and the baseball team reduces their risk that they'll lose a lot of ticket sales due to rain outs.   ( I don't know if farmers and sports teams actually buy or sell weather derivatives but this is just meant to illustrate the example)

So what is a credit default swap? 

During the recent recession and sub prime mortgage disaster the credit default swap was a term that I heard repeatedly.   Wikipedia page defines it : "A credit default swap (CDS) is a swap contract in which the protection buyer of the CDS makes a series of payments to the protection seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default."

In other words a credit default swap is basically just a form of insurance against the default of a bond or loan contract.   If one company buys some bonds they might want to protect themselves against the risk that the bonds will default.  So they might buy a CDS contract as the protection buyer.   They will agree to pay some money in exchange for an agreement from the protection seller to pay the principal value of the bond in case the bond defaults.

Bottom Line : Derivatives is a broad term for a wide variety of financial contracts based on future events.    

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