Derivatives

In the field of chemistry, a derivative is "a substance that can be made from another substance." In finance, derivatives work on the same principle. These financial instruments promise payoffs that are derived from the value of something else, which is called the "underlying." The underlying is often a financial asset or rate, but it does not have to be. Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal. Should we fear derivatives? Most of us choose to fly an airplane even though they sometimes crash. But we also insist that planes are made safe as it makes economic sense for them to be. The same logic should apply to derivatives.

Derivatives come in flavors from plain vanilla to mint-chocolate chip. The plain vanilla include contracts to buy or sell something for future delivery - contracts involving an option to buy or sell something at a fixed price in the future and contracts to exchange one cash flow for another along with simple combinations of forward, futures and options contracts. At the mint chocolate chip end of the spectrum however, the sky is the limit.

A "forward" contract obligates one party to buy the underlying at a fixed price at a certain future fate (called the maturity) from a counter party who is obligated to sell the underlying at that fixed price.

"Hedging" consists of taking a financial position to reduce exposure to risk.

Options: A "call option" on a stock gives its holder the right to buy a fixed number of shares at a given price by some future date, while a "put option" gives it's holder the right to sell a fixed number of shares on the same terms.

A "swap" is a contract to exchange cash flows over a specific period. The principal used to compute the flows is the "notional amount."

Some of the earliest derivatives were linked to tulip bulbs in Holland and to rice in Japan in the 17th century. But derivatives markets were small until the 1970s, when economic conditions, along with advances in the pricing of derivatives, led to spectacular growth. In that decade, the volatility of interest rates and currency exchange rates increased sharply, making it imperative to find efficient ways to hedge related risks. In 1972, the Chicago Mercantile Exchange started trading futures contracts on currencies, the Chicago Board Options Exchange, where stock options are traded, was founded in 1973. In the late 1970s and early 1980s, the swaps market took off. Exotic derivatives took off a few years later.

Derivatives are priced by constructing a hypothetical replicating portfolio. First, individuals and non-financial firms face much higher trading costs than financial institutions. Derivatives make it possible to hedge risks that otherwise would not be possible to hedge. A second important benefit is that derivatives can make underlying markets more efficient.

Derivatives that trade in liquid markets can always be bought or sold at the market price, so mathematical models are not required to value them. Valuation is much more problematic when trading is illiquid. In these cases, models have to be brought to bear to value derivatives - a procedure called "marking them to market," sometimes degenerating into "marking them to myth." Derivative trading does not require much cash. Swaps, for example, have no value at initiation, so a firm with a good credit can build a big portfolio of them without writing checks. As a result derivative trading can look very profitable when its revenue is compared to the cash investment.