EFA (16): Derivatives
Derivatives are the subject of the 16th item in our Economics for Amateurs (EFA) series. You can find the series here each Monday.
So, what are derivatives? They are financial products that are derived from an existing asset, whether real or financial. For example, if instead of today buying or selling a sum of US dollars, or a commodity such as coffee, you agreed to buy them at some future date at a fixed price, that would be a forward contract, one form of derivative.
This example shows an important purpose of derivatives: to allow traders and companies to hedge the risk of movements in currency or commodity prices. Increasingly, however, derivatives are bought and sold for speculative purposes — that is, simply to make a profit.
Another common form of derivative is a “futures” contract. Unlike single, trade-related forward contracts, futures contracts are standardized agreements to buy or sell specific amounts and qualities of commodities at future dates. Financial futures are similar agreements based on financial assets, such as government bonds. These futures contracts are then bought and sold. In most cases, the underlying asset never changes hands.
Options are also derivatives. If you buy an option, you have the right to buy or sell an asset, such as a currency or a share in a company, within a given time period. “Call options” give you the right to buy the asset, while “put options” give you the right to sell it.
Imagine, for example, that the market price of a share in company X is $105. Imagine also that, for $10, you buy a call option, which gives you the right to buy the share for $110 within the next six months. If the market price rises to $125, you could exercise the option to buy the share for $110, sell it at the market price of $125, and make a profit of $5 ($15 minus the $10 you paid for the option).
Note that the market price of a derivative moves in response to the price of the underlying asset. But derivatives typically cost only a small proportion of the price of the underlying asset (in our example, the share). This can lead to much larger percentage profits than if the assets were bought directly.
But speculative derivative trading can also lead to enormous losses, for example for sellers (or “writers") of options. For this reason, credit derivatives have been criticized for causing instability in financial markets and being a cause of the recent financial crisis.
Another typical derivative is an interest rate swap. For example, one company may have taken out a loan at a fixed interest rate, while another has taken out a variable-rate loan. If both companies thought it would be advantageous, they could agree to swap their loan conditions. Likewise, companies could agree to swap loans taken out in different currencies.