A colleague (non-econ) asks: What’s a “derivative” in plain terms?  The plainest answer, yet not very helpful, is that derivatives are a Wall Street cross between the Frankenstein  monster and the blob: they’re a banker-made monster that’s out of control and swallowing the global economy.

But let’s look at derivatives in a less inflammatory way.  Derivatives are a very broad class of financial contracts (also called securities) that depend on some other financial contract for their value.  That “other financial contract” is called the underlying security. Before we get to derivatives, though, let’s look at the most basic “underlying securities”, or what we consider “fundamental” financial contracts or securities.  These include stocks in companies (also called equities), debt contracts (mortgages or bonds), commodities contracts (purchase of actual physical things such as wheat, oil, gold, etc), and foreign exchange (purchase some other currency with a different currency).  These are the contracts that most people think of when they think of Wall Street. These are transactions where something of value in the real world is being bought/sold. When fundamental transactions happen, ownership of something real changes hands for a price.  Example: you buy 100 shares of Acme Rockets stock at $20 per share. You pay $2,000 to the seller now and you get 100 shares of ownership of Acme Rockets.  What determines the price of an underlying fundamental security? Well it’s supply-and-demand, who wants to buy it and who wants to sell it and for how much.  But there’s an underlying real-world economic logic to the valuation over the long-haul.  Over the long-haul, today’s price of a stock should be related to the future profitability and growth of the company. The price of bond today depends on the interest rate the debtor pays, how long to maturity, etc. Same for a mortgage. Today’s supply-and-demand for real-world physical oil or wheat determines today’s “cash” price for delivery of those commodities now. When a fundamental contract transaction (equity, bond, commodity, or foreign exchange) happens, the price is set, the deal is done right now, and it’s over.  It’s just like buying milk at the store today. Go through the check-out line, pay the money, get the milk, done deal.

In contrast, derivatives involve promises about future transactions. A derivative contract involves a promise by one party, the contract seller, to deliver or sell some other financial contract in the future at a price that is fixed now.  The promised contract is called the “underlying security”.  The original class of derivative contracts were called futures contracts and options contracts. Both have some valuable uses in the real world, but both can be prone to abuse.  The idea is generally to manage the risk of some future price movements in the underlying security. Let’s look at a couple examples.

Example 1: Suppose a farmer, we’ll call him Curly, has corn planted on his farm. It’s May.  Based on his experience he expects to harvest and sell x bushels of corn next September. Right now, in May, the price of corn is relatively attractive.  Let’s say the cash delivery price for corn in May is $100. Curly’s afraid that when September comes, the price will drop. He wants to lock in the current price and make his life predictable and less uncertain. Curly sells a futures contract for September delivery.  In other words, Curly sells his promise to sell in the future.  The futures contract itself sells for maybe $1.  In other words, Curly gets $1 to get him to promise to sell at the fixed price of $100 in Septemeber no matter what cash prices are in September. Who would buy such a promise? Well maybe it’s Kellogg’s who wants to nail down the future price of raw materials. Or maybe it’s a speculator like Larry. He sells the contract to Larry. The contract establishes that Larry, the buyer/owner of the futures contract, promises to pay $100 for x bushels of wheat in September and that Curly promises to deliver x bushels at pre-determined spot for $100 in September.  The contract makes sense to Larry since he expects corn to be selling for $104 in September and he plans on taking the delivery at $100 and immediately selling it for $104.  If Larry is right, then he spends $1 now in May and makes $4 in September.  He triples his money with very little actual cash involved up front. Of course, if Larry is wrong and the September price is $98, then he’s out the original $1 for the contract and he’ll lose $2 on the corn in September. In effect, Larry is making a bet on the future price of the fundamental commodity price in the future.  A futures contract is a derivative. Larry could sell his futures contract to yet a third party, say Moe, in July if wants. Then Curly must deliver to Moe. The present price of a futures contract is (in theory) determined by the price movements of the underlying security.

Example 2:  Stock Options. Suppose Groucho, a stock market speculator, thinks that Acme stock is going to rise from $100 per share to $120 a share in the next year. Groucho only has $10,000 in cash right now. He could buy 100 shares at $10, wait, then sell for $12. He makes a $2.000 profit, or 20%, in one year.  But Groucho doesn’t care about actually owning the company, he’s only interested in stock price movements. So instead of buying the stock itself (the underlying security) he buys an option contract.  The option contract says Groucho has the right, at his choice, to purchase Acme stock for $100 per share at any time for the next 12 months from a particular seller. Who would sell a contract like this? Well suppose a pension fund already owns lots of Acme stock. The pension fund doesn’t think it will rise that high, or if it rises that high then they want to cash out and take their profits. The pension fund sells the options contract to Groucho at a price of $0.50 per share.  So Groucho puts his whole $10,000 into the options contract.  He buys the right to buy 20,000 shares at $100 in the future from the pension fund.  Suppose the price only rises to $110 instead of what Groucho thought it would do.  Nonetheless, he “exercises” the option. That is, he forces the pension fund to sell 20,000 to him at $100.  He simultaneously tells his broker to sell the 20,000 shares in the open market at $100.  Groucho makes 20,000 times $10 difference in price = $200,000 profit. But of course the original options contract cost him $10,000.  He turned his $10,000 into $200,000.  Nice return. Stock options are like highly leveraged betting on future stock prices.

So derivatives are financial contracts based upon some other financial contracts.  The current price or value of a derivative contract should be rationally derived from the prices of the underlying securities, hence the name derivatives.  In practice, though, derivative contracts allow large numbers of people with large sums to make “bets” on the future price movements of underlying securities.

When this old man was in the brokerage business 35 years ago, futures contracts and options contracts were pretty much the extent of derivatives.  The biggest players were usually firms with legitimate needs to nail down future prices and limit real-world risk. Economics Blog explains as:

How and why do firms use derivatives to hedge risk?

Financial derivatives are a mechanism for managing risk. They involve options to buy or sell at a certain price in the future. This means that a firm can guarantee being able to buy or sell a contract at a certain price.

But that’s all changed today.  Wall Street has expanded the scope and nature of derivative contracts beyond any real-economic needs.  Huge sums are now involved with huge leverage. Wall Street is now a huge global casino.  There are now derivatives contracts such as:

• CDS: Credit Default Swaps – bets on whether some bonds/companies go bankrupt. Buy a CDS along with the bonds you buy and you insure yourself against the debtor going bankrupt. Or skip the bonds completely and simply bet on whether the company will go bankrupt.  The large number of CDS’s on GM bonds in 2009 was one reason why it was impossible to work-out a rescue or restructuring of GM and bankruptcy was the only option.  Major banks and funds who owned GM bonds also owned CDS’s and profited from the bankruptcy, as I predicted before the fact. See also here.
• MBS: Mortgage Backed Securites – The infamous bonds sold who derive their value from the payments received from a pool of home mortgages.
• Collateralized Debt Securities – bonds based on the value and cash flow of a pool of other debt contracts such as consumer credit card accounts or car loans.  It’s not the loans themselves, but it’s based on the cash flow of the loans.
• Interest Rate Swaps – bets on the future movements of interest rates
• Exchange rate swaps – promises to deliver foreign currency at fixed rates at some future data – a bet on exchange rate movements.

The sums are beyond astronomical now.  The world’s total GDP, the total value of everything of real economic value that the entire planet produces each year is in the neighborhood of $65-75 trillion each year.  But 2-3 years ago when the global financial meltdown started, the total value of all existing derivative contracts world-wide was estimated at over $600 trillion.  In oil alone, the total value of all oil futures contracts, if they were actually exercised and resulted in delivery of oil, would require more than 6 times the amount of actual oil we produce.

The derivatives markets are now pure gambling. A casino on a global scale. And like a casino, it’s rigged. It’s possible some individuals to win big. But it’s also possible to lose really, really big.  The house, however, never loses. The global banks that create and operate these derivative contracts and markets, the Goldman Sachs, JPMorgan Chases, Citis, BoA’s, etc. can’t lose.  Heads, they get management and broker fees plus profits.  Tails, they get management and broker fees and the taxpayer or central bank picks up the tab for the loss.