The word “derivative” sprung up on Delancey Place last week. Delancey Place is a brief daily email with an interesting excerpt or quote from a book or magazine article. Reading it is a favorite daily ritual. I am constantly impressed with the quality and diversity of the excerpts. I strongly recommend subscribing. It is free and now available as an poorly publicized but full text RSS feed. You can subscribe at DelanceyPlace.com.
The word derivative can be found in many contexts and it is both a noun and an adjective. Generally it describes anything derived from, formed from or reminiscent of something else. For example penicillin, email and Hip Hop are derivatives. Penicillin is derived from mold. The term email is a portmantae derived from the words mail and electronic. Some, including Guy Davis, might say Hip Hop and Rap are derivatives of the Blues.
Mathematicians and financiers also use derivatives. According to Wolframs’s Mathworld a, “derivative of a function represents an infinitesimal change in the function with respect to whatever parameters it may have.” Wikipedia explains a mathematical derivative as, “the [instantaneous] rate of change of a quantity”. I recall that derivatives and their analogs, integrations, were the heart of undergraduate calculus. I wish my math skills were strong enough to explain that to you. Alas, I must refer you back to Wolframs’ Mathworld and Wikipedia.
As for financial derivatives, I can describe them a little better. A financial derivative is an investment or contract that derives its value from an asset. Thanks to Hillary Clinton, the most well known derivatives are probably futures. A future is a promise to buy or sell an asset on a future date for a specified price. Today, you can buy a December 2012 Crude Oil (Light) contract on the NYMEX for about $63.50. If I bought this contract today come December 2012 the seller of the contract would deliver the oil to me. Conversely I could sell the December 2012 today for about the same price. Come December 2012 I would have to deliver the oil to the buyer. In both cases the contract derives its value from the future value of the asset.
Financial derivatives are most commonly used to hedge against risk. For example a farmer could sell a September corn future today to shield himself from risk the price of corn may fall. This type of derivative can be very helpful to farmers and other commodity producers. They plant the corn today, they sell it today and they get paid today. Come September they deliver the corn. Any risk of the price of the corn crashing is borne by the person who bought the corn derivative contract, not the farmer.
In practice though the futures markets and derivative markets are used primarily by speculators. Very few investors actually take delivery or deliver the underlying asset. More frequently they buy the derivative and then sell it before it comes due. Well as long as they can find a buyer.And this brings us back to the Delancey Place excerpt. The corn and crude oil futures I mentioned earlier are exchange traded, i.e., there are central organizations that standardize the derivatives for sale and help buyers and sellers find each other. This Wall Street Journal excerpt contrasts the exchanged-traded market and the over-the-counter (“OTC”) market:
…The over-the-counter market is far larger than the exchange-traded ones. Derivatives traded in this market had a total face value of about $285 trillion at the end of 2005, up from about $94 trillion five years before, according to the Bank for International Settlements, an association of international banks based in Switzerland…In comparison, exchange- traded derivatives had a total face value of about $58 trillion at year-end, according to the bank group.”
These over-the-counter derivative are traded directly between two parties. This is a little scary because the investments are not very liquid. It isn’t too tough to find someone willing to buy corn or oil futures. Maybe not at the price you want, but you can almost certainly liquidate or sell your contracts. OTC derivatives on the other hand are often described as exotic and are specific to the buyer and seller. With a market of only one buyer or seller, an exotic derivative can be very hard to sell. Combine this with the tendency for derivative traders to borrow heavily to buy the derivatives and you have a rather volatile financial situation and hence an issue worth Wall Street Journal and Delancey Place coverage.
If you would like to try your hand at derivatives trading without risking too much, check out InTrade.com. On InTrade.com you can buy and sell derivatives of baseball, football, World Cup games and political events including Barack Obama winning the White House in 2008. Now if you don’t care for the nuances of financial instruments fret not, Delancey Place doesn’t typically excerpt from such opaque and technical subjects.