Derivatives Explained Simply

In the span of years following the financial crisis that blew up economies worldwide in 2008, you couldn’t turn on the TV or look at a newspaper without encountering this seemingly new, misunderstood, and ‘apparently’ fundamentally evil concept: financial derivatives.

Indeed, if you were paying attention in those dark days when the worst economic meltdown since the Great Depression was wreaking havoc on the citizens of the world, you were sure to read and hear this mysterious word repeated over and over. It seemed that this exceedingly complicated financial idea had almost single-handedly destroyed the global economy.

So, What Are Financial Derivatives?

At their most foundational level, financial derivatives are simply contracts between two or more interested parties.

What sets them apart from other kinds of financial contracts, though, is the means by which the derivatives, well, derive their value. More accurately, what makes derivatives unique is that they derive their value from something known as an “underlying.”

The term “underlying” became a sort of shorthand to describe the types of financial assets that provided the monetary value upon which financial derivatives are based. These underlying financial assets can take many forms: everything from stocks, bonds, and commodities to things as abstract as interest rates, market indexes, and global currencies.

The most important thing to understand about how derivatives work is that the only value they contain is derived from the value of the underlying financial asset. This, in a sense, is what makes them so controversial and, as we learned from the financial crisis of 2008, so volatile.

What Are Financial Derivatives Used For?

While the purposes of trading derivatives are many and inherently complex, there are some general concepts at play in most instances of derivative trading.

Hedging Risks

The primary reason investor trade in derivatives is to hedge their bets against various economic and financial risks. At its root, a derivative is simply a way to transmit financial risk to another party. The risks that these investors are trying to avoid by employing these clever financial instruments include things like interest rate shifts, currency values, and credit ratings.

Leveraging Assets

Through complex financial mechanisms, derivatives are often used to leverage assets. This means that even slight shifts in the value of the underlying asset can potentially result in massive changes in value for the derivative. In other words, when an investor leverages a derivative, she is doing so in the hopes that slight fluctuations in the asset’s underlying value will produce disproportionately large returns on investment.

Tax Avoidance

Another benefit to investing in certain kinds of derivatives is that they can potentially provide the investor with a continuous stream of income, income on which the investor may not be required to pay the capital gains tax.

Speculation

Some might call it gambling, but the idea of speculation with regard to derivatives is that the investor speculates upon which direction the value of the underlying asset will go. If the investor is correct in his speculation, he makes a profit. If he is incorrect in his speculation, he still retains the underlying value of the asset.

What Are the Two Broad Types of Derivatives in Finance?

There are two basic “umbrella” terms that encompass all of the other variations of derivatives. These two broad categories are defined by the ways in which they are traded in the marketplace. These categories are over-the-counter (or, OTC) derivatives and exchange-traded derivatives.

Exchange-Traded, or Listed Derivatives

These types of derivatives are traded by investors through mechanisms called exchanges and clearinghouses. These derivative contracts are known for being highly standardized, a practice that makes the trading process more fluid and the assets more liquid (pun intended).

The trading process of derivatives through these clearinghouses is complex indeed, and certainly out of the realm of this article.

Suffice it to say that the exchanges are made anonymously through the clearinghouse, which becomes a counterparty to all contracts. In doing so, the clearinghouse standardizes the credit risk for all participants—and that’s the hedge.

Over-the-Counter (OTC) Derivatives

As if exchange-traded derivative markets weren’t confusing enough, over-the-counter derivative markets take this complexity to a new level.

The basic idea is that the trades are negotiated and carried out privately between parties according to their individual risk preferences. But there’s more to it than that: these private trades go through trade dealers, who then trade amongst each other. Because these transactions take place directly, without the anonymity of exchange-traded derivatives markets, the contracting parties assume a certain amount of credit risk that they must manage individually.

What Are Some Common Derivative Instruments?

Now that we have at least some nominal idea of the ways in which derivatives are traded in these two types of markets, let’s look at some of the types of derivative instruments used by investors to hedge risk and, of course, make lots of money through returns on investment.

 

Options

In option derivatives, the owner of the derivative retains the right to purchase or sell an underlying asset on or before a predetermined date. The owner, though, has no actual obligation to do so.

This “option” to buy, sell, or do nothing with the derivative is how the option contract helps mitigate risk.

Forwards

A forward, or forward contract, is a type of derivative contract in which two interested parties make an agreement to sell or purchase some financial asset at a later date.

The key to forward contracts is that the price at which the designated asset will be traded in the future—known as the “delivery price”—is negotiated and agreed to by both parties at the time the contract is created.

Like most derivatives, the purpose of forward contracts is usually to hedge the risks associated with currency values and shifting exchange rates.

Futures

Futures are derivative contracts in which the contracted party agrees to purchase or sell off a particular asset on a designated date at a price negotiated at the time of the contract.

This is very similar to forward contracts in that they are both agreements to carry out an exchange on a specified date at a predetermined price set at the time the contract is negotiated.

The difference is that futures contracts are standardized clearinghouse contracts negotiated and carried out in exchanges, whereas forward contracts are non-standardized contracts negotiated and carried out among the contracted parties.

Swaps

These derivative contracts are a way of “swapping” cash at a predetermined time based on the value of underlying assets. There are two basic kinds of derivative swaps: interest rate swaps and currency swaps.

Interest rate swaps are exactly what they sound like; they involve swapping interest rates among the two contracted parties.

Currency swaps are more or less the same thing as interest rate swaps, only in this case, the cash flow that is swapped between the contracted parties includes the principal of the asset in addition to the associated interest.

Read More: Personal Finance Basics They Don’t Teach You In School (But You Should Know)

What About the Derivatives that Led to the Financial Crisis?

Ah, yes. Those notorious derivatives that famously tanked the economy of our friends across the pond — the United States (and then proceeded to tank the rest of the world).

In this final section, we’ll leave you with a brief discussion of two of the most infamous financial concepts in living memory: credit default swaps and collateralized debt obligations. If you start feeling nauseous, just look away.

Credit Default Swaps

First, let’s get a basic definition down. Credit default swaps are, generally speaking, swap contracts in which the seller of the derivative agrees to pay back the investor who purchases it if the underlying debt asset goes into default.

Yes, you heard that right: a credit default swap is a financial scheme where one party sells the derivative (which is based on third party’s outstanding debt) to another party to hedge risks if they think the loan might default.

To make things even more unseemly, there is little to no government regulation on credit default swaps, which leads to speculation. In that case, individuals can speculate on derivatives they don’t own if they think the companies might do into default on the loan.

So, in other words, people place (albeit legal) bets in the hopes that a company will default on their debt, leading to a payout for the speculator.

What Role Did Credit Default Swaps Play in the 2008 Financial Crisis?

It’s hard to say exactly what the ultimate role was that these volatile derivatives actually played in the leadup to the financial crisis. One thing we know for sure is that they were the key factor in the collapse of Lehman Brothers and the subsequent government bailout of AIG. Here’s the Cliff’s Notes version:

1. Lehman Brothers goes bankrupt, defaulting on its bonds.
2. AIG, which had sold many credit default swaps for Lehman Brothers, had insufficient funds to compensate the parties that had purchased the swaps from them.
3. Many, many other companies had also bought and sold Lehman Brothers credit default swaps, and none of them had the funds to pay their respective buyers either.
4. This created fear that, if AIG couldn’t compensate these companies for their credit default swaps on Lehman, a chain reaction would put them all out of business.
5. The government stepped in to help AIG compensate the credit default swap buyers to prevent total economic catastrophe.

But it wasn’t credit default swaps that directly caused the financial crisis — that honour goes to collateralized debt obligations.

Collateralised Debt Obligations

The basic idea behind collateralized debt obligations is fairly simple. Banks bundle up a number of home mortgages into packages called tranches. Why? In theory, the different levels of risk associated with each mortgage in these tranches should average out to mitigate the overall risk.

That is, a single mortgage that does into default means that the lender simply loses that money. However, if the lender bundles up a bunch of mortgages with other less risky loans, and only a fraction of the mortgages go into default, the lender still makes a profit from all of those loans that didn’t go into default.

So where’s the problem? How did this seemingly innocuous financial system cause the worst economic crisis in nearly a century?

The short answer is that, during the early 2000s, as the housing bubble continued to inflate, many of these lenders didn’t properly diversify the collateralised debt obligations. This meant that, instead of a few high-risk mortgages being bundled with lots of low-risk loans, a huge portion of these collateralized debt obligations were comprised primarily of very high risk (so-called “sub-prime”) mortgages.

Soon enough, these loans began to go into default. And, well, the rest is history.

Sources

“Derivative” Investopedia – https://www.investopedia.com/terms/d/derivative.asp

“Derivatives – a simple guide” BBC News – http://news.bbc.co.uk/2/hi/business/2190776.stm

“Understanding Derivatives: Markets and Infrastructure” Chicago Fed – https://www.chicagofed.org/publications/understanding-derivatives/index