Derivatives: Contracts whose price comes from elsewhere

A derivative is a contract. It is worth nothing on its own: its price derives from something else, a share, wheat, a rate.

Let's start with the oldest. A farmer sows wheat. He does not know what price he will sell it at in six months.

Opposite him, a miller fears wheat will become expensive. Both have the same problem, the other way round.

They sign today: one hundred tonnes, at two hundred euros a tonne, delivered in six months. Twenty thousand euros.

That is a forward contract. On an organised market, standardised and dated, it is called a future.

Six months later, wheat is worth two hundred and fifty euros. The miller still pays twenty thousand. He saves five thousand euros.

The farmer gives up five thousand euros. But he slept soundly. What one gains, the other loses.

A future is a commitment. At expiry, both must keep their word, whatever happens.

An option is a right. Not an obligation. You pay a small price to be able to choose later.

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Say: the right to buy a share at one hundred euros in six months. This right costs five euros. That is the premium.

If the share rises to one hundred and thirty, you buy at one hundred. Thirty of gain, minus the premium: twenty-five euros.

If it falls to eighty, you do nothing. You lose the premium, five euros, and not a cent more.

The swap, the third family, is an exchange of flows. Two parties swap payments, for years.

A company pays a variable rate on a one million euro loan. It fears rates will rise.

A bank agrees to pay it that variable rate. In exchange, the company pays it a fixed rate: three per cent, thirty thousand euros a year.

If the variable rate climbs to four per cent, the bank pays forty thousand. The company stays at thirty.

Fourth family: the CDS. Insurance against a borrower defaulting.

For the example: you hold ten million in bonds. You pay one per cent a year, one hundred thousand euros, to be repaid if the issuer goes bust.

The trap: you can buy a CDS without holding the bond. It is insuring your neighbour's house, and hoping for a fire.

In two thousand eight, the insurer AIG had sold CDS on a massive scale. When the defaults came, it could not pay.

The American state had to rescue it. The insurance against risk had become the risk.

The latest arrival: the variance swap. You bet neither on a rise nor a fall, but on the agitation itself.

If the market moves more than expected, the buyer wins. If it stays calm, he loses. Whatever the direction.

Remember one thing: a derivative moves risk, it never removes it. You must always know who is on the other side.