What is a Derivative?

A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset (like a security) or set of assets (like an index). Common underlying instruments include bonds, commodities, currencies, interest rates, market indexes and stocks. 

Generally belonging to the realm of advanced investing, derivatives are secondary securities whose value is solely based (derived) on the value of the primary security that they are linked to. In and of itself a derivative is worthless. Futures contracts, forward contracts, options, swaps, and warrants are commonly used derivatives.

A futures contract, for example, is a derivative because its value is affected by the performance of the underlying asset. Similarly, a stock option is a derivative because its value is "derived" from that of the underlying stock. While a derivative's value is based on an asset, ownership of a derivative doesn't mean ownership of the asset.

There are two classes of derivative products - "lock" and "option". Lock products (e.g. swaps, futures, or forwards) bind the respective parties from the outset to the agreed upon terms over the life of the contract. Option products (e.g. interest rate swaps), on the other hand, offer the buyer the right, but not the obligation, to become a party to the contract under the initially agreed upon terms.

The risk-reward equation is often thought to be the basis for investment philosophy and derivatives can be used to either mitigate risk (hedging) or assume risk with the expectation of commensurate reward (speculation).

For example, a trader may attempt to profit from an anticipated drop in an index's price by selling (or going "short") the related futures contract. Derivatives used as a hedge allow the risks associated with the underlying asset's price to be transferred between the parties involved in the contract.

For example, commodity derivatives are used by farmers and millers to provide a degree of "insurance." The farmer enters the contract to lock in an acceptable price for the commodity, and the miller enters the contract to lock in a guaranteed supply of the commodity. Although both the farmer and the miller have reduced risk by hedging, both remain exposed to the risks that prices will change.

For example, while the farmer is assured of a specified price for the commodity, prices could rise (due to, for instance, a shortage because of weather-related events) and the farmer will end up losing any additional income that could have been earned. Likewise, prices for the commodity could drop, and the miller will have to pay more for the commodity than he otherwise would have.

For example, let's assume that in April 2017 the farmer enters a futures contract with a miller to sell 5,000 bushels of wheat at $4.404 per bushel in July. At expiry date in July 2017, the market price of wheat falls to $4.350, but the miller has to buy at the contract price of $4.404, which is much higher than the market price of $4.350. Instead of paying $21,750 (4.350 x 5,000), he'll pay $22,020 (4.404 x 5,000), and the lucky farmer recoups a higher-than-market price.

Some derivatives are traded on national securities exchanges and are regulated by the U.S. Securities and Exchange Commission (SEC). Other derivatives are traded over-the-counter (OTC); these derivatives represent individually negotiated agreements between parties.

Let's use the story of a fictional farm to explore the mechanics of several varieties of derivatives.

Gail, the owner of Healthy Hen Farms, is worried about the volatility of the chicken market, with all the sporadic reports of bird flu coming out of the east. Gail wants to protect her business against another spell of bad news. So she meets with an investor who enters into a futures contract with her.

The investor agrees to pay $30 per bird when the birds are ready for slaughter in six months' time, regardless of the market price. If, at that time, the price is above $30, the investor will get the benefit as they will be able to buy the birds for less than market cost and sell them on the market at a higher price for a gain. If the price falls below $30, Gail will get the benefit because she will be able to sell her birds for more than the current market price, or more than what she would get for the birds in the open market.

By entering into a futures contract, Gail is protected from price changes in the market, as she has locked in a price of $30 per bird. She may lose out if the price flies up to $50 per bird on a mad cow scare, but she will be protected if the price falls to $10 on news of a bird flu outbreak. By hedging with a futures contract, Gail is able to focus on her business and limit her worry about price fluctuations.

Now Gail has decided that it's time to take Healthy Hen Farms to the next level. She has already acquired all the smaller farms near her and wants to open her own processing plant. She tries to get more financing, but the lender, Lenny, rejects her.

Lenny's reason for denying financing is that Gail financed her takeovers of the other farms through a massive variable-rate loan, and Lenny is worried that if interest rates rise, she won't be able to pay her debts. He tells Gail that he will only lend to her if she can convert the loan to a fixed-rate loan. Unfortunately, her other lenders refuse to change her current loan terms because they are hoping interest rates will increase, too.

Gail gets a lucky break when she meets Sam, the owner of a chain of restaurants. Sam has a fixed-rate loan about the same size as Gail's and he wants to convert it to a variable-rate loan because he hopes interest rates will decline in the future.

For similar reasons, Sam's lenders won't change the terms of the loan. Gail and Sam decide to swap loans. They work out a deal in which Gail's payments go toward Sam's loan and his payments go toward Gail's loan. Although the names on the loans haven't changed, their contract allows them both to get the type of loan they want.

This is a bit risky for both of them because if one of them defaults or goes bankrupt, the other will be snapped back into his or her old loan, which may require a payment for which either Gail of Sam may be unprepared. However, it allows them to modify their loans to meet their individual needs.

Lenny, Gail's banker, ponies up the additional capital at a favorable interest rate and Gail goes away happy. Lenny is pleased as well, because his money is out there getting a return, but he is also a little worried that Sam or Gail may fail in their businesses.

To make matters worse, Lenny's friend Dale comes to him asking for money to start his own film company. Lenny knows Dale has a lot of collateral and that the loan would be at a higher interest rate because of the more volatile nature of the movie industry, so he's kicking himself for loaning all of his capital to Gail.

Fortunately for Lenny, derivatives offer another solution. Lenny spins Gail's loan into a credit derivative and sells it to a speculator at a discount to the true value. Although Lenny doesn't see the full return on the loan, he gets his capital back and can issue it out again to his friend Dale.

Lenny likes this system so much that he continues to spin out his loans as credit derivatives, taking modest returns in exchange for less risk of default and more liquidity.

Years later, Healthy Hen Farms is a publicly traded corporation (HEN) and is America's largest poultry producer. Gail and Sam are both looking forward to retirement.

Over the years, Sam bought quite a few shares of HEN. In fact, he has more than $100,000 invested in the company. Sam is getting nervous because he is worried that another shock, perhaps another outbreak of bird flu, might wipe out a huge chunk of his retirement money. Sam starts looking for someone to take the risk off his shoulders. Lenny, by now a financier extraordinaire and active writer of options, agrees to give him a hand.

Lenny outlines a deal in which Sam pays Lenny a fee for the right (but not the obligation) to sell Lenny the HEN shares in a year's time at their current price of $25 per share. If the share prices plummet, Lenny protects Sam from the loss of his retirement savings.

Lenny is OK because he has been collecting the fees and can handle the risk. This is called a put option, but it can be done in reverse by someone agreeing to buy a stock in the future at a fixed price (called a call option).

Healthy Hen Farms remains stable until Sam and Gail have both pulled their money out for retirement. Lenny profits from the fees and his booming trade as a financier.

This tale illustrates how derivatives can move risk (and the accompanying rewards) from the risk averse to the risk seekers. Although Warren Buffett once called derivatives "financial weapons of mass destruction," derivatives can be very useful tools, provided they are used properly. Like all other financial instruments, derivatives have their own set of pros and cons, but they also hold unique potential to enhance the functionality of the overall financial system.