What the hell is a derivative?

A derivative sounds complicated, but it isn’t really. Most of us have made them without even realising. Fundamentally, a derivative is an contract that DERIVES from something else. Or, to put it in normal speak. It’s when you make a bet with someone. 

I bet you a fiver Sally will eat that last piece of cake there. I’ll put £50 on Billy No Mates coming in first (I love this horse name, because in Spanish, it reads ‘Billy Don’t Kill’). Twenty quid says you can’t run a mile in less than 3 minutes… These are all examples of everyday derivatives. If you want to get geeky about it, in the finance world they would probablyyyyyy be called OTCs futures or forwards. OTC means Over the Counter, ie: not on the standard markets. Futures means both of you definitely have to honour it if it happens, at the time that the market has pre-chosen. Forwards are the same, but you can pick the time and place of exchange.  So if Sally does eat the cake, you have to hand over a fiver at a predetermined time. Even if I say, “don’t worry about it”. We both have to do it. No takebacks, hand it over. There are other types called “options” where you can decide not to pursue it, you have the choice. 

And to be honest, that’s the crux of it. You could stop reading here. A derivative is a bet, the rest is details. Thank you and goodnight. 

But that’s not really the end. Because the next part, is why do finance people use them? Well, there are two main reasons. 

Me, writing about dervatives

Speculative derivatives are like hunked-up versions of the bets we do with our mates or at the bookies 

The first is basically what we’ve done in the examples above, speculating. You think you can make an easy buck. You’re confident that Sally is going to eat that cake, and you want to line your pocket. I get it. 

Traders do this all the time. Especially with currencies, because they are always slightly fluctuating against each other. So, a very simple example would be that you think the euro is going to increase in value as the pound drops. You switch your pounds for euros when you can get a good deal, wait for them to grow, then at the perfect moment you switch it back. Yay! That’s what “FOREX” - foreign exchange - traders do. 

BUT but but but … They do it on STEROIDS. DO NOT TRY TO COPY THEM. 

The thing with these fluctuations is that they are usually only a fraction of a cent. So, if you bought €100 and then changed it back, you might only make less than £1 profit. Which could get eaten up by fees. Pointless. 

Unless you were changing €1 million. Or €100 million. Or €500 million. Then you’re looking at profits of £100,000, £1 million or £5 million. And that’s what FOREX traders do. They will borrow or “leverage” CRAZY money. I mean CRAZYyYyYyYyyyy. And then they basically bet on a currency. When it goes wrong, it goes badly wrong. 

If you want to learn more about the whole bank trading culture, I recommend The Trading Game by Gary Stevenson. You kind of have to have a bit of crazy built-in to do this job. They are the guys who will be at their desks 5am until 1am every day. They have to be really wired all the time, so there can also be a bit of a cocaine culture. Not that Gary is one of them, but that’s the vibe. 

Some people talk about banks as a casino. That’s a huge exaggeration because a lot of research and strategy goes into speculative trades (or it should do anyway!). Entire mathy teams called Quants are dedicated to supporting the trading floor. And they are really geeky about it too. This isn’t Steve down the pub with a hunch. It’s the best of the best.

But there is a little grain of truth to the casino expression. I guess you could think of speculative traders as truly excellent poker players. 

Hedging is like when your mum makes you bring a coat … just in case 

The other sort of motivation for derivatives is called “hedging”. This, to my mind, is a lot more interesting. Right so, the best example I can probably give is the chocolate company Mars. Do you like Mars Bars and derivatives? You’re going to love this. 

So, Mars buy cocoa to make their chocolate. They buy a lot. Between 350,000 and 400,000 tonnes a year according to their website. Of course, they can’t just pop to Tescos to pick it up. They probably can’t even find a cocoa supplier big enough. So they buy it direct from the global commodities market, where you buy in tonnes. 

Right now, it costs $3,210.4 per tonne of cocoa. But that changes all the time. Just like currencies. I found the price from this website, and I can basically guarantee that if you click on it, it will say something different. 

What I can’t guarantee is whether the price will go up or down. Mars can’t either. From the looks of it, the price of cocoa will continue to rise, but we don’t know by how much. Gahh. Nightmare. The guys at Mars know they will need to buy 400,000 tonnes of cocoa next year, and they want to plan their finances, but they have no idea how much it will cost. So what do they do? 

They make a contract! Or a derivative. Or a bet. Basically they lock-in a price now, that they can use later. This will give them a bit of stability. 

Mars say to the market, “look mate. This time next year, I would like to buy 400,000 tonnes of cocoa at $3,000 a tonne, anyone keen?”

The market says, “Done! Agree to this contract, and on this date we’ll sell you 400,000 tonnes for $3,000”. 

Mars says, “Great, thank you! I am now the proud owner of this butt-saving contract”. 

The hedge is in place. Mars breathes a sigh of relief for another year. Chocolate eaters relax into another Milky Way. (Has anyone else noticed Mars’ space theme?). 

But we’re not totally done. Now we have some nuances to iron out. 

Who decided the date that the cocoa will be sold? If the market decides and pops it in a standardised contract, that derivative is called a “future”. If Mars (the buyer) gets to decide the date, and they can hash it out a bit, it’s called a “forward”. Forwards are a bit nicer to the buyer I guess. 

Ok, so new problem. What if 2027 rolls around and it’s actually now $2,000 a tonne? D’oh! In this unlikely situation, the big dogs at Mars (the c-suite not the company’s pet food division) would be absolutely face-palming. Shareholders would be furious. They just wasted $400 million!!! … Well there is actually a way to prevent this. Mars can buy an “option” derivative, instead of a “future” or “forward” and then they are not obliged to honour the deal when the time comes. It’s literally just an option for them. So that’s nice. 

Obviously options are not as great for the markets, because then they have less stability. So get this. They hedge against them. There are derivatives within derivatives within derivatives all over the shop. Not just for commodities like cocoa, copper or oil. But the currencies that buy them. The banks that buy them. All sorts. Whatever you can imagine. It’s your derivative. Famously, in the 2008 financial crisis, a lot of derivatives were swimming around dodgy US mortgages. 

In this case, the type of derivative was a “swap”, which is the fourth main type. (Don’t worry there are only 4!). A swap is a derivative that makes bets on things to do with (unpredictable) money flows, like variable interest rates or someone not paying their mortgage. To explain this one, imagine you’re a mortgage provider or bank. 

Ok so, you have given someone a mortgage. But, bollocks. They default. Now it’s your problem. You need that money. How are you going to pay your staff? Your rent? Your salary? What if they all default? To prevent your firm from plunging into debt, you could take out a credit default swap. It’s a derivative which says, “if this person doesn’t pay, you pay me”... or “I bet this much money that they won’t pay”... or “I go short on this person paying”. (Introducing a little jargon there for the lols). Obviously you don’t want them to default, but you have to be prepared in case they do. You could make the bet on the interest only if you like. One of the 80 bazillion problems with the 2007-era swaps was that they morphed from hedging into speculation, and it got very dangerous because bankers were gambling on people’s livelihoods. 

So, I would say hedging is like bringing an umbrella out, JUST IN CASE. If it looks like it will deffo rain, like Mars looking at the price of cocoa rising, they are a life saver. But in the case that you have too many derivatives it can get extremely messy. Like carrying hundreds of umbrellas. Expensive too. 

I guess that’s it! 

That’s more or less the basics of derivatives. To sum up: They are contracts based on something happening or not happening. They are kind of a bet. But an educated one. 

There are two main motivations for derivatives, you can speculate which is literally betting. This is what a lot of crazy FOREX traders do. And then you can hedge, which is a strategic way to help businesses and banks maintain stability. I didn’t mention it much here, but hedging helps our pension funds stay on track instead of swinging too wildly with the market madness. 

“Forwards” means that the buyer can chose the date of exchange, and if the thing happens - say Sally eats the cake - they MUST pay up. “Futures” means that the date and time of exchange is already pre-determined in the contract before the buyer gets involved. They agree to the pre-existing terms. “Swaps” are really focused on cash-flow risk. As a freelancer, I can’t tell you how appealing that sounds haha. 

“Options” give the holder a lot more control than “futures”, because they don’t need to honour the contract if something gets cheaper or basically the opposite of the hedge happens and its good for them. 

There are some other things which I think would be useful to know. I’ll pop them in a glossary below. 

Glossary: 

• Forward: We’re making a bet, and you (the buyer) can pick the exchange date
  

• Future: We’re making a bet, and the exchange date is market-standardised and pre-set in the contract
  

• Option: We’re making a bet, and you (the buyer) don’t need to honour it… But I do!

  • Put option: You have the option to SELL at an agreed price

  • Call option: You have the option to BUY at an agreed price
    

• Long: When you bet something WILL happen “I’ll go long £5 on Sally eating the cake” => I think Sally will eat the cake
  

• Short: When you bet something WILL NOT happen “I’ll short £5 on Sally eating the cake” => I don’t think Sally will eat the cake