Derivatives in a nutshell

Excerpt from my book All About Derivatives, 2nd Edition.


When you first learned about trees as a child, someone no doubt pointed to one and said “Tree!” and not “Norway Maple!” and certainly not “Acer platanoides!” Only later did you learn there are many types of trees, alike in some ways and different in others. This method of learning employs the concept of abstraction and our brains are rather wired for it. We can learn about derivatives the same way. What then is a derivative in the abstract? A derivative is a price guarantee.

Nearly every derivative out there is just an agreement between a future buyer and future seller, or counterparties. Every derivative specifies a future price at which some item can or must be sold. This item, known as the underlier, might be some physical commodity such as corn or natural gas, or some financial security such as stock or a government bond, or something more abstract like a price index (we’ll explain those in just a bit). Every derivative also specifies a future date on or before which the transaction must occur. These are the common elements of all derivatives: buyer and seller, underlier, future price, and future date.

Just like a shrub is much like a tree but not exactly like a tree, some derivatives guarantee something other than a price. Chief among these are credit derivatives. These are performance guarantees, not price guarantees, and we’ll cover those in their own chapter. And weather derivatives guarantee things like temperature or rainfall. Still, the vast vast majority of derivatives are price guarantees, so it’s plenty safe thinking of them like that for now.

As do trees, derivatives come in various shapes and sizes (but not nearly as many!). Some derivatives are so simple they are known as “vanillas” and are employed nowadays with no more fanfare than when a plumber uses a wrench. Other derivatives are known as “exotics” and are so complex that the counterparties themselves may not truly understand them (this can lead to quite a bit of trouble). It turns out all derivatives, no matter how exotic, are variations or combinations of just four basic types:

A forward is a contract wherein a buyer agrees to purchase the underlier from the seller at a specified price on a specified future date.

A futures is a standardized forward contract executed at an exchange, a forum that brings buyers and sellers together and guarantees that both parties will fulfill their obligations.

A swap contract is an agreement to exchange future cash flows. Typically, one cash flow is based on a variable or floating price and the other on a fixed one.

An option contract grants its holder the right, but not the obligation, to buy or sell something at a specified price, on or before a specified future date. Most are executed at an exchange.

The chapters that follow delve into the fundamental characteristics of, and differences among, these four related contracts. We’ll see, for example, that a forward contract is like a highly customizable futures contract. And a swap is essentially a bundle of related forwards. Forwards, futures, and swaps commit their parties to a future transaction, whereas the option conveys no such commitment to its buyer. The option, however, is the only one of the four with any inherent value upon inception. And because they are exchange-traded, futures and options tend to be more liquid (there are more of them traded on a given day) and fungible (one is as good as another) than are forwards and swaps.

Despite such differences, the forward, futures, swap, and option are all just variations of a price guarantee. And they are the pulleys and pistons from which virtually all derivative contraptions are built.

Why are they called derivatives?

A derivative is often defined as “a financial instrument whose value derives from that of something else.” It’s a fair definition but slim. Let’s dissect and expand it a bit to see what this “deriving” is all about. Oh, and remember the derivatives you learned about in calculus? If you ever took calculus? Homonyms. These aren’t them.

A financial instrument is just a standard type of agreement, or contract if you will, that bestows certain financial rights and responsibilities to its parties. A mortgage is a type of financial instrument whereby in return for making monthly payments (your responsibility) you get to keep your house (your right). Stock is a common instrument that grants a right to some portion of a company’s equity, or worth. Currency notes are instruments (Japanese yen, U.S. dollars, etc.) that grant a right to purchase. Term life insurance is another common instrument that pays out some cash should you expire before it does. And so on.

Quite importantly, instances of financial instruments have value. Shares of Microsoft may be selling or “trading” on the New York Stock Exchange for $30.82 each, whereas shares of IBM may go for $130.68. Those are their values, or, loosely speaking, their prices. One British pound may trade for 1.55 U.S. dollars and a 10-year U.S. Treasury note may trade for $979.69. None of these qualify as derivatives because their values do not depend directly on that of another instrument or commodity. Stock prices are determined by earnings expectations, supply and demand, and who knows what. Currency prices are determined by interest rates, confidence in the issuer’s economic health, and so on.

Derivative financial instruments also have value. But unlike non-derivative instruments, their values are tightly linked to the current market price of their underlier. Consider a tortilla maker who 6 months ago contracted with a farmer to buy 1,000 bushels of corn today for $25 per bushel (an example of a forward contract, by the way.) Say the market price of a bushel of corn, known as its spot price (the price you can buy it “right here on the spot” for immediate delivery) is now $28. What is the value of the tortilla maker’s contract today? For each bushel of corn, they pay 3 dollars less than they would have to pay on the spot marketso the contract must be worth 1,000 times 3 dollars or $3,000. Were the spot price of corn not $28 but $30, the contract would be worth $5,000 using the same math. As you can see, the value of this contract depends quite a lot on the spot price of corn. Now there are other factors in the valuation of a forward contract, but the value of this and any derivative is principally derived (hence the name “derivative”) from the spot price of its underlier.

Intuitively we might think of “value” as something positive. But with derivatives (and many non-derivative instruments), a value can just as easily be negative. It all depends on one’s perspective. In the previous example, we examined the value of the forward contract to the tortilla maker. What is the value of that same contract to the farmer? With a spot price of $28 and contract price of $25, the farmer must sell those bushels to the tortilla maker for 3 dollars less than they could in the spot market. So to them the contract must be worth 1,000 times -3 or a negative $3,000. Whether a derivative’s value is negative or positive depends chiefly on which side of the deal you are on. In this sense many types of derivative are known as zero-sum games, as for every winner with a positive gain there is a corresponding loser with an offsetting loss.

How derivatives are used

You might think there are a zillion different reasons for using derivatives, but it turns out they are mostly used for just one of two basic functions: hedging and speculation. Hedgers use derivatives to manage uncertainty, and speculators use derivatives to wager on it.

Hedgers use derivatives to reduce financial risk, or the prospect that the price of things might “move against them.” Consider our tortilla manufacturer who knew 6 months ago they would need to buy corn today. They faced the prospect of corn prices rising excessively in the meantime and used a forward contract to mitigate that risk. They might also have used a futures contract, or even an option. The key observation here is that financial risk occurs naturally, and derivatives can be applied to reduce, or hedge, that risk. Chapter 7, “Using Derivatives to Manage Financial Risk” is all about hedging.

Speculators use derivatives not to reduce financial risk but to potentially profit from it. Doing so is known euphemistically as “taking a view” of future prices, because “taking a view” sounds more legitimate than “gambling.” But speculating really is little more than gambling on an uncertain outcome. If one has a view that IBM’s stock price will be higher in 6 months than it is today, he or she can buy options to buy IBM stock in 6 months at today’s price.1 If their prediction comes true they can profit handsomely. If not, they lose whatever they have paid for the option—or 100 percent of their investment. That’s speculating.

It’s worth noting that hedgers can hedge and speculators can speculate without derivatives. Many hedges and views can be executed by trading just the underlier. Then why use derivatives? Because derivatives use a powerful financial force known as leverage. Technically, it refers to doing something with borrowed money. And just as a nutcracker exploits leverage in the physical world, focusing mechanical energy so even a child can crack the hard shell of a nut, derivatives focus “financial energy” so hedgers and speculators can get more work done with less effort. Consider our IBM speculator. Instead of buying options, they could have simply bought up a bunch of stock and held it for 6 months, making the same basic “upside” when (and if) their prediction came true. By using options they make the same basic play but lay out much less cash up front, as stock options are much less costly than the stock itself. But leverage does not come for free—and to the speculator its price is increased “downside” risk. When the IBM speculator using options was wrong, they lost 100 percent of their investment. Had they purchased stock, they would have lost only some fraction of their investment. And they would still have that stock, which could yet appreciate in the future.

Two other users of derivatives are market-makers and arbitrageurs. Market-makers are the merchants of derivatives. Not unlike fishmongers and fish, they buy at one price and sell at a higher price, pocketing the difference as their profit. They might also eat one now and again (not always by choice), but mostly they act as sellers to want-to-be buyers and buyers to want-to-be sellers, and they like to do so by taking on as little risk as possible. (We’ll see how in a later chapter.)

Arbitrageurs also avoid taking risks. They search for mispriced securities and attempt to profit from them—taking on no risk whatsoever if they do it right. If an arbitrageur sees the exact same option trading in one market for $5 and in another for $5.10, and can simultaneously buy at $5 and sell at $5.10, they make a dime with virtually no risk. While “arbing” is harder and harder to do as markets become more efficient, the very fact they exist is a powerful driver of how all derivatives are valued. We’ll see how later on. There are others with an interest in derivatives—regulators, accountants, systems developers, etc.—but hedgers, speculators, market-makers, and arbitrageurs account for most of them.

And where do investors fit into the world of derivatives? Most investors, certainly most small investors, do not trade derivatives. They simply aren’t necessary to achieve their investment objectives. Some investors do use derivatives, however, as hedgers or speculators. Later on we’ll learn about protective puts one can apply to stock positions to reduce the risk of loss in the event of a market downturn. And as we saw above, the IBM investor used options to speculate on the future price of IBM stock.

Derivative markets

So where do derivatives happen? They happen in markets where they are traded. Now “trading a derivative” just refers to a buyer and seller coming together and committing themselves to one of these price guarantees. A trade, then, is one of these transactions. These parties to a trade are known formally as counterparties. And just as there are markets for buying and selling nonderivative instruments such as stock (think New York Stock Exchange) and mortgages (think your bank), there are well-established markets for trading derivatives. And as with nonderivatives, there are two basic types of derivative markets: over-the-counter markets and exchange markets.

The over-the-counter or OTC market is where two parties find each other then work directly with each other—and nobody else—to formulate, execute, and enforce a derivative transaction. If I am an oil driller and you are a refinery, we might execute a forward contract for the sale of X barrels of crude oil at a price of Y to be delivered Z days from today. We can set X, Y and Z however we like, as this a completely private affair. This ability to tailor a contract to the exact needs of the counterparties is among the chief benefits of OTC derivatives. Forward contracts are by definition OTC instruments, and most swaps are traded OTC as well.

The exchange market (sometimes known as the listed market) is where a prospective buyer and seller can do a deal and not worry about finding each other. The exchange provides market-makers who act as sellers for those who wish to buy and buyers for those who wish to sell. It provides this feature, known as liquidity, by establishing and enforcing strict definitions for derivatives tradable on the exchange. So a buyer or seller gives up the ability to customize a deal, but in return need not worry about finding a counterparty. Futures contracts are by definition exchange-traded instruments and most options (not all) are traded on an exchange as well.

Another crucial distinction between OTC and exchange markets relates to guarantee of performance. With an OTC trade, the two parties have no fundamental assurance that the other side will hold up their end of the deal. When it comes time to execute a transaction, the seller may decide not to sell or the buyer may decide not to buy. With an exchange trade, the exchange itself (actually a clearing organization associated with the exchange) guarantees that all counterparties will fulfill their responsibilities. It provides this assurance with margin accounts and daily marking to market, two mechanisms we will examine later on.

Beyond the exchange and OTC markets there are also derivatives “markets” where the “traders” don’t even know they are trading derivatives. Consider the typical mortgage that allows the borrower to pay off the balance early without penalty. The borrower has essentially executed an embedded option giving them the right, but not the obligation, to terminate the agreement. Another example is the convertible bond issued by many corporations, which gives the bond-holder an option to convert their position into company stock. (Arbitrageurs have a field day when the implied price of these embedded options diverge from the price of actual options.) We won’t delve into these “stealth” markets in this book, but rest assured that the fundamentals of derivatives apply to those markets just as they do to the traditional exchange and OTC markets.