What on earth is a Derivative?! Swaps, Options, Futures and all that Jazz
Derivatives are financial assets that’s value depends on some other underlying thing (i.e. it is derived from something else). For example the value of a stock index will have an impact on a derivative on that index. They can seem hideously complex and have been held responsible for may of the ills in the financial system. As far back as 2003 Warren Buffet was calling them ‘weapons of financial mass destruction’.
Derivatives are not new and started off life in agricultural commodities hundreds of years ago. When a farmer fixes a price to sell his crop at in the future, this is a future contract. Futures contracts have also been used on tulip and rice speculation over the years!
A Futures contracts obliges you to do something (buy or sell), it is a contract after all. An Option gives you the right but not the obligation to buy or sell.
Going back to our stock index example. If you bought a future on say the FTSE you would be obliged to buy it according to the terms of the contract. If the price you agreed to buy at (the strike price) was higher than the market price when you came to buy, you’ve lost out (out of the money), if it’s lower (and you are buying cheaper) you are said to be ‘in the money’. At the same price – on the money. All futures do is give you certainty on the price and when you have to pay.
An option works in much the same way, but you don’t have to buy (or sell). You can look at the market price at the time and decide whether it’s worth your while or not. For this you pay a premium. The valuation of derivatives is very complex. The most common method was devised by Black & Scholes (who won a Nobel Prize for it), but this has weaknesses so has been superseded by even more complex methods.
Derivatives can be used for speculation, but also to hedge your position (so they are not all bad) There are variations on these themes, such as covered warrants, Credit Default Swaps (CDS) contracts for difference (CFDs) and spread betting which all have their roots in the derivative world.
Be very cautious when dealing with any of these derivative based products. The pricing is not always transparent and you can find yourself with a huge (potentially unlimited) loss. Banks love them as they make lots of money from them (especially the ‘premium free’ ones – don’t worry you are still paying) often in the form of a structured product. There are other risks as well such as counter-party risk (your derivative is probably sold on, but to who? This happened when people thought they had bought something safe and discovered that Lehman’s were behind it – who were then bust)
As with all weapons: Handle with care.