Derivatives helped blow up our financial markets and wreck our economy in 2008. Yet most Americans - and most members of the U.S. Congress - still have no idea what derivatives are, nor how they wrecked our economy.
If you're one of these people, don't worry. We'll fix that here.
While pundits and market players seem to enjoy making the topic more difficult than it is, in real simple terms a derivative product derives its value from an asset or product that has not yet been created.
So, for example, over 100 years ago, if a wheat farmer wanted to avoid sticker shock at the market they might offer to sell their entire crop to a buyer six months in advance. This made sense because a wheat farmer not only knew what they would receive for their wheat the day they arrived at the market but the purchaser of the wheat knew how much they would spend on a product months in advance.
The resulting wheat contract derives its value from what's going to be produced and delivered to market in six months. Hence the name derivative contract.
Depending on the weather, droughts, gluts, disease, transportation problems, etc. either the seller or buyer of the wheat could do very well. In all cases, securing a price for products in advance - or in the future - allowed America's commodity markets to stabilize and become more dependable.
This enabled all involved to plan for the future.
The formal recognition of the importance of these transactions was noted with the creation of the Chicago Board of Trade (CBOT) in 1848, where trading in "forward" or "to-arrive" goods occurred. Derivative contracts with future prices already cooked into the contract became standard practice. Farmers, dealers and other merchants flocked to the CBOT, which officially began publishing "futures" prices in 1877.
If the buyer of wheat decided that they didn't need the wheat, or if the seller of the wheat didn't want to farm, but knew another farmer who did, the contract(s) could be bought or sold to others. This helped facilitate market efficiency. Over time, banks and other traders recognized that those holding "futures" contracts held something of value and began extending loans based on the derivative contracts.
As you can imagine, if the wheat farmer doesn't show up things can get ugly. This is especially the case if the dealer who purchased the contract has already promised (sold) the wheat to another market player.
How derivative contracts, that were once the domain of agriculture commodity markets, came to be dominated by the financial commodity markets that collapsed the American economy in 2008 (as Warren Buffet suggested they would) will be discussed in my next post.
- Mark
FYI: To help avoid confusion, because derivative contracts derive their value from something that is supposed to happen in the future keep in mind that they are often referred to as both futures and derivative contracts.
Part II on this topic: Derivatives Explained ... The Financial Commodity Tidal Wave.
Part III on this topic: Derivatives Explained ... Why Financial Derivatives Are Still Dangerous.
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