Do You Understand How Derivatives Work?

I have been a derivatives trader for the majority of my working career. I’ve noticed during that time that the word “derivatives” has garnered some very negative connotations. The fact of the matter is that the term derivative has a variety of meanings and can indicate a wide range of financial instruments. Let’s start out with a basic definition of a derivative.

A derivative is a financial instrument like an option and or futures contract whose value is derived partly from the value of another security, which is the underlying security. I don’t suppose that technical definition shared a tremendous amount of light on the actual meaning of the derivatives. In layman’s terms, a derivative is a bet as to whether the value of the underlying security, which might be a stock, bond, or financial index, will increase or decrease by a specified date. Derivatives are typically used to protect asset prices and things like inventories or potential future purchases. In reality, derivatives are a generic term for a wide class of financial products. Some of these products, like futures contracts and options, are well-defined and enjoy a relatively widespread understanding.

On the other hand, there are classes of derivatives which exist in a murky and poorly understood environment. These derivatives are usually not traded publicly, but are individual contracts between firms to buy and sell products, or insure against loss (as is the case in credit default swaps) or give a firm the right to buy a product in the future a set price. These non-traded derivatives can be classified as exotic in nature. By exotic, I mean they are each unique to a finite situation that exists between two parties. As you have probably heard on the news, many of these exotic derivatives are poorly understood by both the public and the government. Further, there have been questions raised as to the legality of these derivatives. As an aside, the new financial regulation packages proposed by the government include extensive scrutiny and regulation of exotic derivatives.

But getting back to my job, I work only with the “plain Jane” variety of derivatives called futures contracts. Futures contracts are traded on regulated exchanges and there is a high degree of transparency in their daily trading activity. Futures contracts have been around for more than a century, and early derivatives date back to Rice trading in Japan in the 1600s. So the garden-variety derivative, or futures contract, is well understood and heavily traded.

You might be surprised at the wide range of commodities, metals, financial indexes, and a host of other unusual futures contracts that can be traded. For example, there are futures contracts on energy products, bond prices, meats and a host of other contracts. Generally these contracts are used to lock-in prices for producers of the products listed above, or the investors of the products listed above. Futures allow a producer to lock-in a price so a firm can produce and price their product with the future in mind.

It’s important to understand that well-regulated futures provide a valuable service to industry. On the other hand, exotic derivatives have, at times, resulted in extraordinary losses and the most recent derivative problem caused our country to fall into a recession. The purpose of this article is to differentiate between normal, transparent derivatives contracts and the exotic derivatives contracts that have caused so much trouble for our economy.

Source by David S. Adams

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