Securities Law Explainifier #C: DERIVATIVE

A derivative is a financial instrument that derives its value from the value of something else. Essentially, a derivative is a bet on what the price of the underlying asset will do. There has been a fully-functioning derivatives market in the United States since the mid-nineteenth century. (see: Markham, “CONFEDERATE BONDS,” “GENERAL CUSTER,” AND THE REGULATION OF DERIVATIVE FINANCIAL INSTRUMENTS, 25 Seton Hall L. Rev. 1 (1994))

A fixed-rate contract with a heating oil company is a derivative. That’s because the contract itself has value, but its value depends on the price of heating oil. Heating oil is the underlying asset. Imagine you typically use 100 gallons of oil during the winter and you sign a fixed-rate contract when the price of oil is $4 a gallon. The following week the price goes down to $3 a gallon. Your heating oil company owns a contract worth $100 (the difference between the market price of oil and the contract price). If the price of oil stayed at $4, the contract would be valueless, and if the price of oil went up to $5 the contract would be worth $100 to you.

Derivatives are often used as a hedge. Hedging is essentially making a bet and, just in case, also making the opposite bet. It’s like betting $100 on the long shot and $30 on the favorite. The potential gains are less, but so are the potential losses.

The main species of derivative are:

Forwards - an agreement to sell the underlying item at a set time, place and price (our heating oil contract is a forward).
Futures - like forwards, but with standard terms.
Options - a right to sell (put) or buy (call) the underlying item at a set price.
Swaps - an agreement to trade the cash flow from one transaction for another. Like this:
1. Party A borrows 30,000 US Dollars and party B borrows 15,000 UK Pounds.
2. A gives the 30,000 Dollars to B and B gives the 15,000 Pounds to A
3. A pays B's monthly payments and B pays A's monthly payments
4. At the end of the term, A and B exchange money again

The swaps market dwarfs the other derivative markets. Swaps exist in a constellation of sub-types: interest rate swaps (one party borrows money at a fixed rate the other at a floating rate), basis swaps (two different fixed rates), commodity swaps (one fixed, one based on the price of a commodity), and on and on. For more about derivatives I suggest:

Nagler, DERIVATIVES DISCLOSURE REQUIREMENTS: HERE WE GO AGAIN, 6 Cornell J.L. & Pub. Pol'y 441, (Winter 1997)

AN INTRODUCTION TO OTC DERIVATIVES, 848 PLI/Corp 121, (1994)