# Financial Derivatives

Could someone explain how financial “derivative” securities work, such as “futures,” “put options,” “swaps.” etc?

Thanks.

Here’s my brief and incomplete summary. When people think of market trading, they usually think of what are called “cash instruments”. You can buy a bushel of grain, for instance, or a share of stock in IBM, or a company bond, which means you’re loaning money to a company in exchange for repayment later. You can trade in your dollars for euros. All these are cash instruments. You can go to the market and find out exactly how much each of these things are worth, because you’re buying and selling actual assets.

In addition to these, though, there are financial instruments that aren’t directly based on assets, but are contracts whose value derives from the value of these assets, and there are called derivatives.

People categorize derivatives in different ways, but for purposes of this post, there are three kinds of derivatives; futures, options, and swaps.

Futures are contracts to buy or sell something at a future date for a price fixed in the contract. So, you could have a contract that says, “On March 1, Farmer Brown will sell to the other party in this contract 100 bushels of wheat at \$6 per bushel” Then, when March 1 comes around, the other guy holding the contract gets his 100 bushels of wheat.

Options are like futures, except, instead of mandating that a transaction takes place at a certain date, they give the options holder the right to do it. A call option gives someone the right to buy a security at a certain date at a certain price, and a put option gives someone the right to sell a security at a certain date at a certain price. So, I might have a call option, expiring March 1, on 100 shares of IBM at \$125. That means that on that date (or in America, on or before that date), I have the right to exercise my option and buy 100 shares of stock for \$125 a share, no matter what the price is on the open market. If I don’t exercise my option by March 1, it goes away.

A swap is a contract to exchange parts of financial instruments by a certain date, but swaps give me a headache, and I’ve never really understood them, so I’ll let someone else explain them.

Captain Amazing has given a pretty good overview.

As far as swaps, like the Captain said, its a contract to exchange some type of cash flow.

Take an interest rate swap as an example. Imagine you are a bank who borrows money at a floating rate but you make loans at a fixed rate. You have a mismatch in cash flows. If the rates go up, the interest you pay increases but the interest you receive does not. So a broker and find someone with the opposite problem and set up a contract. You pay fixed payments under the contract and receive a foating rate payment. The aim is that if interest rates increase, you will receive an additional payment under your swap contract in order to better match your cash flows.

Same thing applies with a foreign currency swap. The object is to set up a contract where you are not exposed to currency risk.

Now there are many different swaps out there “Total Rate of Return Swaps” “Credit Default Swaps” which are pretty different. In my opinion, those are more or less insurance contracts.

The theory say in the farmer example is that Farmer Brown is skilled in farming, but is not necessarily skilled in playing the market in prices for his goods. So by doing a futures contract, he can lock in a price now and let the market go where it may.

You’ve gotten good answers so far. The key thing to remember is that a “derivative” is just that - something which is “derived” from something else. For example, the value of a call option is derived (i.e., based upon) the value of the underlying stock (amongst other factors).

Wikipedia has good descriptions for many of the derivatives you mentioned. Another good site is Investopedia. To forewarn you - derivatives comprise a very large and continually evolving area of finance. The basic or “plain vanilla” versions of most derivatives are not too hard to understand, but there are virtually endless permutations which can be very difficult to understand (or value). Don’t feel bad, though - even the PhD eggheads on Wall Street have difficulty valuing complex derivatives (even ones they created).

There are really two types:

1. A hedge. As pointed out above, you don’t know which way certain things are going (a certain stock price, interest rates, commodity prices, etc. etc.), so you buy a derivative that moves the other way. You are balancing things – if it goes up you make money one way, if it goes down you make money the other way. No matter which way the markets move, you end up making some money (or at least losing less money – Think about an airline buying derivatives on fuel prices).

2. A gamble. You have some reason (a guess? analysis? a wish?) to believe some financial instrument is moving in some direction, but you don’t have any coverage on the other side. If you guess right, you make a ton of money. If you guess wrong…

Historically derivatives were used for case 1. They can be used to lower risks and stabilize markets. Then people discovered case 2. They amplify and destabilize markets. When you add in ‘leverage’, this gets even worse.

First you need to understand the difference between a future and a forward. I future is an exchange traded derivative that is standardized. By standardized, I mean, for example, that it may only be available to trade in increments of 1,000 units or something like that. Forwards, on the other hand, are customized contracts between two parties and do not trade on an exchange.

A swap is nothing more than a series of forward contracts.

A more simple way of saying this is that deriviatives can either be used for hedging or speculative purposes. There aren’t really two different types. There is one type (of many different variations) that may be used for different purposes.

Thanks everyone all this really helps.

Futures are heavily used in a lot of industries.

For instance, you buy an airline ticket today for a trip six months from now. The airline will need to buy jet fuel in six months to fill the plane. If jet fuel goes up, they’ll have lost money on your ticket - so they buy the jet fuel now on the futures market. Of course, if jet fuel goes down, they haven’t made as much as they could, so they might hedge.

Hedging happens a lot in foreign currency transactions - you are going to pay me in Euros six months from now on a price agreed to today, I might buy Euros now so no matter what happens I get the money I expect, not the whatever the Euro is worth six months from now.

Second the idea that derivatives are complex. Warren Buffett is one of the smartest and best investors in the country, and even he was tripped up when a company he purchased had a big exposure in derivatives. He warned against them, saying, among other things, that “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

Oil futures are the reason that Southwest can run those annoying “no charge for baggage” ads. They’re annoying to me because Southwest doesn’t fly into airports near me.