Glossary · Funds and derivatives
Derivatives
A derivative is a contract whose value comes from the price of something else, such as a stock, oil, a currency or an interest rate.
Also called: derivative, financial derivative, derivative contract
In plain words
A concert ticket is not the concert, but its value depends on the concert: if the band becomes famous, your ticket is worth more. Financial derivatives work the same way. They are contracts whose value “derives” from something else, called the underlying: a share price, the price of oil or wheat, an exchange rate, an interest rate, a stock index.
The four basic kinds are forwards, futures, options and swaps. A farmer can use one to lock in the price of a harvest months ahead; an airline to fix the price of its fuel; a bank to protect itself against rising interest rates. That is hedging: paying to reduce risk.
Others use the same contracts to bet. Because a derivative usually costs a fraction of the thing it tracks, a small move in the underlying can mean a big gain or loss: derivatives come with built-in leverage.
Example
An airline locks in its fuel price
An airline will need 10 million gallons of jet fuel in six months. Fuel costs $2.50 a gallon today, and a rise would wreck its budget.
- It signs a contract to buy the fuel in six months at $2.60 a gallon: $26 million.
- If fuel jumps to $3.20, it still pays $26 million instead of $32 million: the contract saved $6 million.
- If fuel falls to $2.00, it still pays $26 million instead of $20 million: the contract cost it $6 million.
- Either way the airline knew its fuel bill in advance. The person on the other side took the risk instead.
A hedge does not make money on average; it swaps an uncertain cost for a known one.
One level deeper
Derivatives are old. Merchants agreed future prices for goods in ancient times; the Dojima rice market in Osaka traded standardized rice futures in the 1700s; the Chicago Board of Trade opened in 1848. Today the biggest are interest-rate swaps between banks and companies.
Some trade on exchanges, standardized and backed by a clearing house. Others are private deals between two parties (over the counter), which can be tailored but carry the risk that the other side cannot pay. The Bank for International Settlements counts over-the-counter contracts with a face value of hundreds of trillions of dollars; the money actually at risk is a small fraction of that.
In 2008 derivatives showed their dark side. The insurer AIG had sold huge amounts of credit default swaps, a kind of insurance on mortgage bonds, and could not pay when those bonds collapsed; the US government rescued it. In his letter to shareholders for 2002, Warren Buffett had called derivatives “financial weapons of mass destruction”.
Why it matters
They let companies, farmers and governments shed risks they do not want: a price rise, a currency drop, a jump in rates.
They let speculators take big positions with little money, which adds trading but can also magnify crashes.
Their prices carry information: options prices, for example, show how much the market expects stocks to swing (the VIX).
A common mistake
Myth: Derivatives are just gambling.
In fact: The same contract can be a bet or insurance, depending on who holds it. For the airline that buys fuel futures it is insurance; for a trader with no fuel needs it is a bet on the price. Both are needed: the hedger needs someone willing to take the risk.
Questions people ask
What are the main types of derivatives?
Forwards and futures (an agreement to trade later at a price fixed now), options (the right, not the duty, to buy or sell at a set price) and swaps (exchanging one stream of payments for another, such as fixed interest for floating).
Why are derivatives called derivatives?
Because their value is derived from something else, the underlying asset or rate. A contract on oil rises and falls with the price of oil.
Are derivatives risky?
They can be. Many come with leverage, so a small move in the underlying can wipe out what you put in or more. Used to hedge, they reduce risk; used to bet with borrowed money, they magnify it.
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About the numbers
- This page explains a term. It is not investment advice.