What are derivatives ?
Derivatives, as the name implies, are financial instruments that derive from something and have become famous in mainstream media after the financial crisis in 2008.
Derivatives normally have the function of insurance or hedging and transferring the financial risk between two parties.
This category can include any instrument whose price is based on the value of another asset, defined as “underlying” (such as, for example, shares, financial indices, currencies, interest rates, commodities
We can explain the derivatives with an example
Luca is a guy who has a family tradition. For the Christmas lunch in his very large family they consume 10 swordfish for a total of 200 kg of fish.
The tradition has lasted for years and Luca is in charge of supplying the fish.
It happens, however, like the year before that Luca had difficulty finding fish to continue the family tradition and mindful of all the extra work done the previous Christmas, for this Christmas he wants to be prepared and never repeat the bad experience.
Then Luca moves in search of a large fish farm in his area and contacts the farmer.
Luca asks to the farmer if he can assure him the supply of fish for next Christmas. The owner is not convinced, but offers Luca to buy the 10 swordfish in advance.
If Luca pays now, the owner guarantees him the supply of the 10 fish.
However, the price will fluctuates through the year, so they agree on a total price that satisfies both of 100 euros.
The owner of the farm then creates a note (IOU) equivalent to the value of 100 euros for 10 fish that can be collected when the owner wishes by a certain date before Christmas.
What we have now is a contract, an agreement that is derived from what is his underlying, in this case the purchase of swordfish, with an indicated quantity within a period of time
So the derivative is a contract based on an underlying.
There are 3 types of derivatives contracts:
The first is the future forward, which is essentially our example, that is the delivery of 200 kg of swordfish in the future.
The second type is called option, which is a future as previusly but with the option to buy or sell.
In the example given Luca may be worried of the risk of not having the fish or farmer may not be 100% reliable.
So Luca protects himself with a purchase option with another breeder, and pays 20 euros for the right to buy the 200kg of fish before Christmas.
So Luca will have this purchase note for the 200kg of fish and he now has the right to exercise this option before Christmas.
Luca therefore now to be absolutely sure of having these 200kg of fish has opened a futures contract with the first farmer for 100 euros and in addition he protected himself from any problems with an option with the second farmer.
An case all goes well with the first breeder, the option will simply expire and be forgotten.
The third type is called SWAP.
It is applied to instruments that have variable interest over time, so if you want to switch to a fixed rate, the bank will take the risk of the spread between the two rates, trying to earn from it.
The underlyings of this type of derivative can be commodities, interest rates, credit rates, etc.
The interesting thing about derivative contracts is that they can be traded and are traded on exchanges or OTCs (i.e. face-to-face agreements between people)
In our example it could happen that Luca and his family have to skip Christmas lunch.
Knowing this, Luca can sell the purchase contract to a friend of his, who could offer him 80 euros for those 20kg of fish.
In this case Luca would lose some currency but he would not have to withdraw the fish and would have recovered part of the money spent.
Otherwise, it could happen that swordfish is nowhere to be found that Christmas and Luca could sell the contract for those 20 kg for 200 euros, displeasing the family but making an excellent gain.
What is important in derivatives is the contract and not the underlying. The underlying is a problem when it creates a toxic asset with the derivative, as we explained in our video dedicated to this issue.
Luca in our example is absolutely not a risk, the risk for Luca is the first breeder.
In the event that all the fish died, Luca would remain with the only contract without validity and without fish and for that he is covered with the option.