Derivatives Trading

Lore & Background

Derivatives are one of the three main categories of financial instruments, the other two being equity (i.e., stocks or shares) and debt (i.e., bonds and mortgages). The oldest example of a derivative in history, attested to by Aristotle, is thought to be a contract transaction of olives, entered into by ancient Greek philosopher Thales, who made a profit in the exchange. However, Aristotle did not define this arrangement as a derivative but as a monopoly (Aristotle's Politics, Book I, Chapter XI). Bucket shops, outlawed in 1936 in the US, are a more recent historical example. One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century. Derivatives may broadly be categorized as "lock" or "option" products. Lock products (such as swaps, futures, or forwards) obligate the contractual parties to the terms over the life of the contract. Option products (such as interest rate swaps) provide the buyer the right, but not the obligation to enter the contract under the terms specified. Derivatives can be used either for risk management (i.e. to "hedge" by providing offsetting compensation in case of an undesired event, a kind of "insurance") or for speculation (i.e. making a financial "bet"). Along with many other financial products and services, derivatives reform is an element of the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010.

In Their Own Story

The screens glow blue in the dim office, reflecting off the polished mahogany desk. A single phone rings, unanswered. On the main monitor, a chart spikes violently, red candles consuming green ones in seconds. The trader does not blink; he knows this volatility was invited, not accidental. Across town, a rival CEO watches his net worth evaporate as options expire worthless against him. It is silent warfare, waged with numbers instead of bullets.

Reader's Guide

Derivatives are contracts between two parties that specify conditions (especially the dates, resulting values and definitions of the underlying variables, the parties' contractual obligations, and the notional amount) under which payments are to be made between the parties. The assets include commodities, stocks, bonds, interest rates and currencies, but they can also be other derivatives, which adds another layer of complexity to proper valuation. There are two groups of derivative contracts: the privately traded over-the-counter (OTC) derivatives such as swaps that do not go through an exchange or other intermediary, and exchange-traded derivatives (ETD) that are traded through specialized derivatives exchanges or other exchanges. Derivatives are broadly categorized by the relationship between the underlying asset and the derivative (such as forward, option, swap); the type of underlying asset (such as equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives, or credit derivatives); the market in which they trade (such as exchange-traded or over-the-counter); and their pay-off profile. Lock products are theoretically valued at zero at the time of execution and thus do not typically require an up-front exchange between the parties. Option products have immediate value at the outset because they provide specified protection (intrinsic value) over a given time period (time value). One common form of option product familiar to many consumers is insurance for homes and automobiles.

Did You Know?

• The oldest example of a derivative in history, attested to by Aristotle, is thought to be a contract transaction of olives, entered into by ancient Greek philosopher Thales.
• One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century.
• As of June 2011, the over-the-counter (OTC) derivatives market amounted to approximately $700 trillion, and the size of the market traded on exchanges totaled an additional $83 trillion.
• Warren Buffett referred to credit default swaps as 'financial weapons of mass destruction' in a famous 2002 speech.
• Derivatives reform is an element of the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010.