What are derivatives?

In most cases derivatives are contracts to buy or sell the underlying asset at a future time, with the price, quantity and other specifications defined today. The contract may bind both parties, or just one party with the other party reserving the option to exercise or not. The underlying asset either has to be traded or some kind of cash settlement has to transpire. Derivatives are traded either in organized exchanges or over the counter. Examples of derivatives include forwards, futures, options, caps, floors, swaps, collars, and many others.

Examples of Derivatives

Here is my most favorite example, not only because it makes the whole concept easy to understand, because it dates back to the days of Aristotle.

There came a time that Thales of Miletus had been told that being a philosopher was not a valued career because it had left him penniless. Amongst his skills was the ability to deduce future weather trends from his observation of the stars. Although it was still the dead of winter, he determined that the following year would produce a good crop of olives. Taking what little money he had, he put down deposits on all the olive oil-presses in Miletus and Chios. This gave him first rights to the pressing services when the following year's olive harvest came. He did not have to pay much in deposits because he was the only bidder and the press operators were happy to have a bit of money during their off-peak season.

When the time came for the olive harvest there was indeed a large crop. Competition for time on the oil-presses was keen as each oliver grower raced to beat the other growers to market with their crop of olive oil. Of course, Thales of Miletus had all of the time locked up for himself, and he very successfully sold portions of his time at whatever price he cared to ask.

He made a lot of money, and demonstrated that if a philosopher has no money then it is by his own choice!

There are two basic types of derivatives: Forwards and Options. The contracts could be over-the-counter or Exchange Traded. Exchange traded forward contracts are known as futures contracts.

All derivatives provide some sort of leverage. There is usually some cash paid up although bank-to-bank contracts, and certain corporate transactions, can get by on credit.

When dealing in exchange traded contracts, the investor has to make an up front (initial) payment (place margin) as well as cover unprofitable moves in the contract's price (variation margin). Initial margin represents the exchange’s calculation of what an investor stands to lose on a bad day. Variation margin tracks the actual market performance of the contract. The investor will either gain or lose on a day-toy-day basis. Money has to be deposited on a daily basis to cover losses.

Forwards

A Forward Contract is a firm agreement by two parties to buy or sell something. The "something" could be foreign currency, precious metals, oil, sugar, coffee, or almost anything else. A slight variation on the Forward Contract is the Forward Contract for Differences (FCFD). This is a Forward Contract except that it is settled in cash based upon price movements.

A Forward Rate Agreement (FRA) is used by corporate treasurers to protect against future short-term interest rate costs (or returns). Contracts for Differences provide a way for mortgage lenders to provide fixed rate mortgages.

Options

An option gives the buyer the right but not the obligation to buy or sell something in the future. Just like Forwards, an option contract can be written on just about anything that two people are willing to buy or sell.

Derivatives provide Finance Directors with very useful tools for managing risk. However, because they are an "off-balance sheet" transaction, and do not usually require a significant cash outlay, they investor can quickly find himself in financial trouble if the deal goes south.

Does it sound too good to be true?

Derivatives can be very rewarding but they can also entail risk -- a lot of risk. Remember to never let fear or greed rule your investment strategy. Common sense is the third line of defense. It a deal sounds too good to be true, then it's probably not true.