You've probably heard about derivatives and you must have always wondered what they really are. Today is your lucky day. We're going to explain to you exactly what they are, so you'll never have a question mark in your head again when they talk about derivatives.
A derivative can be translated as secondary product. This occurs in several categories, such as chemistry, biology, industry, software, and the perhaps familiar fork, which is a derivative of the underlying blockchain, such as Bitcoin Cash. You can think of those as derivatives of Bitcoin.
What this story is about are financial derivatives. These are investment instruments that are derived from a particular underlying asset. Considering the underlying value of a financial derivative, we should think of things like financial derivatives, stocks, commodities and other physical products or precious metals. Derivatives have historically actually been designed to hedge risk, but it is now clear that they are also used by the financial markets for not-so-nice things, as the story below will show.
There are several types, including some well-known derivatives:
CFD (Contract For Difference)
FRA (Forward Rate Agreement)
These are the most well-known, but also infamous, derivatives.
An option is a right (not an obligation) to buy or sell a certain asset within a certain period. Sometimes the price is fixed in advance. The value of the option depends on the value of the underlying product, the term, the interest rate and the volatility of the value of that product. Well-known things to take an option on are real estate and stocks.
The Ancient Greeks were already trading options when using olive presses. If the harvest was good, you could put more olive presses to work for an agreed price at minimal risk. If the harvest failed, you could use fewer olive presses if you had purchased an option to do so, thus reducing your risk.
The derivative on government debt in Venice around 1400 is also fairly well known, a kind of early precursor to bonds. In the 20th century, options trading only really took off in the Western world. From the latter trading in derivatives came the terms call and put.
The literal translation of a swap is an exchange or trade. A swap is a financial product in which one party exchanges a cash flow or risk with another party. The two parties are called the legs of a swap. There are several forms of swaps, such as the Interest Rate Swap (IRS). This swap did become somewhat notorious in a variety of cases, such as the Vestia affair. The purpose of an interest rate swap is to hedge the risks of interest rate volatility.
After the credit crisis, many interest rate swaps were "worth" a negative amount, resulting in interest rate swaps that represented a debt instead of an asset. Many SMEs and semi-public institutions such as schools and hospitals suffered great financial losses as a result. The Libor affair also sounds familiar to many people. The Credit Default Swap (CDS) also comes from these regions. It is notorious for the collapse of Lehman Brothers. A CDS is used to transfer risks of default or bankruptcy to the next layer in this swap.
Party A borrows 10 million euros from Party B through a CDS. Party B insures against the risk of default of the original investment with Party C, and so on. The problem was that eventually no one knew who the original borrower was and who had the original risk. It was actually a very opaque financial product, with many people going down the drain because the original risk was sky-high without their knowledge. The fall of Lehman Brothers marked the beginning of the credit crisis.
From the swap world also comes the margin call. This is a situation that occurs when a swap threatens to get out of control. As soon as unacceptable risks emerge for one of the parties in the swap, a margin call follows. This means that the collateral deposited at the beginning of the swap is assigned to the winning party to terminate the swap. This risk is the focus of the 2011 film "Margin Call."
A future, also known as a forward contract, is a financial contract between two parties in which they commit themselves to trading the underlying product at a predetermined expiration date at a predetermined price (forward price). In this financial instrument, the buyer has the long position, and the seller has the short position. Basically, they are betting against each other. During the tulip mania in the seventeenth century, futures were traded on the Amsterdam Stock Exchange to hedge a bad crop.
For obvious reasons, there are standardized futures, such as a grain future that covers exactly 5,000 bushels of grain of a certain quality. In agricultural products, this is necessary to establish the fair value of a derivative. Standardized contracts are used primarily with products that would become technically unsaleable without a set price by quantity and quality.
Futures exist in many areas, such as financial futures (e.g., stock, currency, interest rates) and commodities or bulk commodities (e.g., oil, gold, grain).
After a future expires, a private investor is not waiting for delivery of 1000 kilograms of potatoes or so, so one can choose to sell the future just before physical delivery or one can have the price difference paid out. Otherwise, you will be seeing yourself sitting behind a table in the local market! Potatoes!
Futures are very often used to cover positions, also called hedging. One then usually hedges day trading positions. You can also choose the Daily Settlement Price (DSP), where you get paid per day or must pay per daily result. With futures, one also works with short, long and the margin call.
These CFDs are used as a contract between investors, where the seller pays the difference between a certain price when buying and selling certain underlying assets. If this difference is negative, the buyer pays. The trader in a CFD never becomes the owner of the underlying asset himself.
The CFD was invented in the 1990s as a leveraged product and thus uses borrowed money. An investor takes the contract from a provider who may set his own terms. When prices fall, the provider may take the necessary collateral and possibly throw a margin call on top. In that case, additional payments must be made on top of the forfeited collateral. A contract for difference does have the advantage over other types of derivatives that an absolute stop loss can be agreed upon, where you can only lose your deposit.
This derivative is used to fix interest costs or interest income. Two parties say that, for example, the Euribor interest rate will be at 2% in 6 months. The buyer wins if it rises and loses if it falls. The difference is paid to the counterparty by the loser.
In general, it is safe to say that trading in derivatives should be left to professionals and highly experienced investors. Leverage allows for huge profits when things go well, but for large losses or even bankruptcy when things go wrong. Private investors are advised to first use virtual derivatives with a software program to practice "dry" derivatives trading because while this financial instrument promises high potential profits, losses can often be unlimited.
Derivatives scandals are well known, such as the Vestia case, the Libor interest rate affair, Enron and the collapse of Barings Bank. Popular derivatives can be purchased on a stock exchange or over the counter (OTC derivatives, between two investing parties). The first form is standardized, while OTC is a bespoke deal.
Warren Buffett, the legendary stock trader, said of derivatives that they were "financial weapons of mass destruction" and that the so-called "mark to model" (pricing model) was a "mark to myth" in the case of derivatives. "The big short" is a movie set just before the credit crisis. It is an amusing film with a top-notch cast that, for variety, focuses on the positives of going short against the banks and their real estate and the protagonists getting stinking rich. It actually happened, too.
The 2008 credit crisis was a confirmation of the words of Warren. Many American derivatives assumed that the price of real estate would always go up. When this turned out not to be the case, the owners of these derivatives had to be bailed out with government aid ("too big to fail"). The Oscar-winning documentary film "Inside Job" tells the story of the 2008 financial crisis from its prelude to its consequences. Perfectly watchable and compellingly told.
Large investors (including banks, governments, pension funds and other financial institutions) quickly caught on to this game and so they continued to speculate, because they would be bailed out by the government anyway when things went wrong again and, after all, investing in derivatives can make a lot of money when things go well. It came down to this: when things go well we are rich, when things go wrong the taxpayer pays. It could not go on like this.
Dijsselbloem, the Dutch ex-minister of finance, tried after the credit crisis to restrict the trade and possession of derivatives for government agencies, but the danger of the dominoes when investing in derivatives is still lurking in other sectors (e.g., pension funds).
Coarse estimates of the total value of derivatives speak of between 10 and 20 times the total GDP of the entire world. A value of 1.2 million billion euros is often mentioned, but this is already outdated. In figures, this is 1,200,000,000,000,000,000. One does not have to be Warren Buffett to understand that this must go wrong yet again. The derivatives time bomb is ticking. Who knows what is left on the clock?