What is a derivative? I’m going to provide you with a really vague general definition because there are so many different kinds and they have so little in common, but here’s what all derivatives have in common – they are contracts settled based on the price of something else. The amount of money that changes hands is based on the price of another thing. Thus, a derivative agreement derives its value from the price of the other item. The other thing is called an “underlying” or “reference” asset. A fixed-rate contract with a heating oil company, for instance, is a derivative. The contract itself has value, but its value depends on the price of heating oil. Heating oil is the underlying asset. Imagine you typically use 100 gallons of oil during the winter and you sign a fixed-rate contract when the price of oil is $4 a gallon. The following week the price goes down to $3 a gallon. Your heating oil company owns a contract worth $100 (the difference between the market price of oil and the contract price). If the price of oil stayed at $4, the contract would be valueless, and if the price of oil went up to $5 the contract would be worth $100 to you. Derivatives are often used as a hedge. Hedging is essentially making a bet and, just in case, also making the opposite bet. It’s like betting $100 on the long shot and $30 on the favorite. The potential gains are less, but so are the potential losses.
It is, I believe, easier to understand how derivatives work if you bear in mind that they were invented to manage risk – they make reference to the price of another item because they are a mirror image of that investment. Derivatives must be carefully matched to the underlying risk to ensure that they reduce risk without canceling the possibility for profit. When you make an investment, you’re trying to do something impossible - predict what’s going to happen in the future. Some would call this insurance and some, gambling – that’s a thread running through this discussion – and while it is often difficult to tell the difference, one accepted way of distinguishing is that gambling creates risk. Federal regulation has often been aimed at keeping the gamblers (or speculators) out of the market. So, when you enter into a derivative contract, you’re making, and you can’t make a bet without there being a house - you need someone on the other side who disagrees with your vision of the future. Everyone who bets that oil’s going up needs to find someone who thinks oil’s going down. The party on the other side of the contract is called the “counterparty.”
Allow me to use an example to explain why risk-matching is important in hedging - imagine you own a gift shop in a touristy seaside town, and you expect a hot, sunny summer, you might buy more sunglasses than usual. The problem is that if you’re wrong and it rains all summer you might end up in big trouble – all your capital is tied up in sunglasses and a rainy summer is a bad time to try to liquidate sunglasses. You might be better off holding onto your stock and hoping to sell them next year. So, to hedge against that worst case rainy summer, you buy some umbrellas. So, if you do have a rainy summer you can limp along selling umbrellas and hold onto your sunglasses. If you aren’t interested in going into the umbrella business you could buy a derivative based on the price of umbrellas that will pay you money if the price of umbrellas goes up. Notice that if you spend too much money on your umbrella hedge you could (1) cancel out your potential sunglasses profit or even (2) end up with bigger bet on rain than sun. So, your umbrella hedge needs to be carefully scaled to your sunglasses play.
Allow me to use an example to explain why risk-matching is important in hedging - imagine you own a gift shop in a touristy seaside town, and you expect a hot, sunny summer, you might buy more sunglasses than usual. The problem is that if you’re wrong and it rains all summer you might end up in big trouble – all your capital is tied up in sunglasses and a rainy summer is a bad time to try to liquidate sunglasses. You might be better off holding onto your stock and hoping to sell them next year. So, to hedge against that worst case rainy summer, you buy some umbrellas. So, if you do have a rainy summer you can limp along selling umbrellas and hold onto your sunglasses. If you aren’t interested in going into the umbrella business you could buy a derivative based on the price of umbrellas that will pay you money if the price of umbrellas goes up. Notice that if you spend too much money on your umbrella hedge you could (1) cancel out your potential sunglasses profit or even (2) end up with bigger bet on rain than sun. So, your umbrella hedge needs to be carefully scaled to your sunglasses play.
Allow me to use an example to explain why risk-matching is important in hedging - imagine you own a gift shop in a touristy seaside town, and you expect a hot, sunny summer, you might buy more sunglasses than usual. The problem is that if you’re wrong and it rains all summer you might end up in big trouble – all your capital is tied up in sunglasses and a rainy summer is a bad time to try to liquidate sunglasses. You might be better off holding onto your stock and hoping to sell them next year. So, to hedge against that worst case rainy summer, you buy some umbrellas. So, if you do have a rainy summer you can limp along selling umbrellas and hold onto your sunglasses. If you aren’t interested in going into the umbrella business you could buy a derivative based on the price of umbrellas that will pay you money if the price of umbrellas goes up. Notice that if you spend too much money on your umbrella hedge you could (1) cancel out your potential sunglasses profit or even (2) end up with bigger bet on rain than sun. So, your umbrella hedge needs to be carefully scaled to your sunglasses play.
Derivatives are classified by the kind of underlying asset, by the method of connecting the assets value with the transaction, or both. Underlying assets range across a tremendous swath of items – wheat, electricity, interest rates. The main species of derivative are: Forwards - an agreement to sell the underlying item at a set time, place and price (our heating oil contract is a forward). Futures - like forwards, but with standard terms and no requirement to deliver the actual thing. Options - a right to sell (put) or buy (call) the underlying item at a set price. Swaps - an agreement to trade the cash flow from one transaction for another. These are radically different from the other things we just discussed – more about swaps later. Because there are so many types of instruments covered by the term derivative, it doesn’t really make sense to talk about them as a monolithic thing. SO First, let’s talk about commodity futures …
Commodity futures are the original modern derivative. They were developed to address a weakness is farming as a business model … A farmer does a whole year's work for one market period - everything is in the balance. What the market does is controlled by the weather and other things that the farmer can’t control. Example of the 2009 cherry crop - because of weird weather conditions all the cherries were ripe during the same week. Price of cherries dropped so low that cost of harvesting cherries was greater than potential profit. Cherries didn't get picked at all. Farmers lost the entire year's investment. Agricultural futures allow farmers to lock in the prices ahead of time to ensure that their labor won’t be for naught. They were developed to help farmers hedge risk
The problem was solved in Chicago. As you can see from this map, between 1850 and 1860 the US railhead moved from Boston to Chicago. As a result, Chicago became the place where produce and livestock were gathered to be sold. Chicago became the nation’s agricultural marketplace. In 1864, at Chicago’s central commodity trading facility, the Chicago Board of Trade, the first standardized futures contract was signed. Present-day commodity futures markets have all the same paraphernalia as stock exchanges – a floor, brokers, traders, clearinghouses, etc.
The problem was solved in Chicago. As you can see from this map, between 1850 and 1860 the US railhead moved from Boston to Chicago. As a result, Chicago became the place where produce and livestock were gathered to be sold. Chicago became the nation’s agricultural marketplace. In 1864, at Chicago’s central commodity trading facility, the Chicago Board of Trade, the first standardized futures contract was signed. Present-day commodity futures markets have all the same paraphernalia as stock exchanges – a floor, brokers, traders, clearinghouses, etc.
The problem was solved in Chicago. As you can see from this map, between 1850 and 1860 the US railhead moved from Boston to Chicago. As a result, Chicago became the place where produce and livestock were gathered to be sold. Chicago became the nation’s agricultural marketplace. In 1864, at Chicago’s central commodity trading facility, the Chicago Board of Trade, the first standardized futures contract was signed. Present-day commodity futures markets have all the same paraphernalia as stock exchanges – a floor, brokers, traders, clearinghouses, etc.
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