Most seem to know that the financial crisis of 2008 was based, at least in part, on the derivatives market, but others tend to see derivatives as arcane and mysterious—even a bit scary.
To some extent, that’s true. Risk managers combine various types of derivatives into strange, new financial engineering packages that can be difficult to understand. Plus, the size of the derivatives market—sometimes estimated as high as $1.2 quadrillion, or 10 times the size of the total world gross domestic product—means that it will naturally be a bit scary.
Below is an explanation of the three major types of financial derivatives and how they are used in the financial market, so that you can improve your financial skills and understanding.
What Are Financial Derivatives?
While it might sound complicated, a derivative is simply any financial instrument that gets its value from the price of something else. And because it’s a derivative, the value of this agreement is based on the predetermined and current price of the "something else."
Financial derivatives come in three main varieties:
- Forward contracts
- Futures contracts
- Option contracts
Below is a closer look at what each of those varieties mean.
Forward Contracts
Simply put, a forward contract is an agreement between parties to buy or sell an asset at a predetermined price on a future date. At the time that a forward contract is negotiated, both parties agree upon the price, quantity, and date that an asset is to be delivered. Since these contracts are private agreements that are not traded on an exchange, they’re relatively less rigid in their terms and conditions.
Forward Contract Example: Predicting the Wheat Harvest
Imagine you run a bakery. It's January, and you’re setting up your budget for the year. You're going to purchase a bunch of wheat during the harvest season in June or July, but don't know what the price of wheat will be by then. If the weather is bad, the wheat harvest could be poor and the price could be high; if wheat is abundant, the price could be low.
So you call up a wheat farmer and offer to buy 1,000 bushels of wheat for $8 per bushel. The wheat farmer agrees, and now you can both plan on that transaction taking place—no matter what happens to the wheat harvest or price. If it turns out the wheat harvest is poor and the price of wheat jumps to $10, you've made $2 per bushel. If the wheat harvest is good and the price of wheat drops to $6, you've lost $2. You can make plans knowing that you’ll pay exactly $8 per bushel, however, and eliminating that risk has a lot of value for you and the farmer.
The wheat example is what’s called a forward contract. You’re simply agreeing to buy or sell something at a predetermined time for a predetermined price.
Futures Contracts
A futures contract is very similar. The only difference is that is takes place on an organized exchange. That means there's a liaison between you and the farmer who makes sure everyone keeps their agreements, and it often means the arrangement is closed out before delivery of a cash payment. In other words, when the July harvest comes and the price of wheat turns out to be $10 per bushel, the wheat farmer pays you just $2 per bushel for the 1,000 and lets you buy wheat from anyone you want at the market price, which means you'll be paying $8.
Futures Contract Example: Setting the Price of Rice in Feudal Japan
One of the oldest futures markets was created in 1697 in the province of Osaka, Japan to organize the purchase and sale of rice. Known as the Dojima Rice Exchange, it filled a very important role in the Japanese Shogunate economy. During this period, samurai, including the feudal lords, were paid exclusively in rice. You can imagine how this might be a frustrating currency to be paid in; as the value of rice fluctuated, so, too, would the value of this annual payment.
The samurai needed a solution, and the financiers of the Dojima Rice Exchange created one: a futures market. Now, samurai and their lords could offer to sell their future paychecks (in rice) for a set value, eliminating the fluctuations in their pay. This meant that they could take out loans and provide an expectation of repayment, regardless of the price of rice. Soon, the samurai were converting their rice futures-based value into paper money and holding bank accounts at the Dojima Rice Exchange. This exchange would become one of the forerunners to the modern Japanese banking system.
As you can see, forwards and futures—while sometimes presented as strange or mysterious finance terms—are not actually terribly hard to understand. In fact, they’re ancient.
Related: Finance for Non-Finance Professionals: 14 Terms You Need to Know
Options Contracts
An option can be defined fairly simply: It’s the right, but not the obligation, to buy or sell something at a predetermined price—and, in some cases, at a predetermined time. In other words, an option lets you take the benefit from the upside of a forward contract, while avoiding the downside, and this flexibility costs a small fee.
There are several types of options and combinations of options. The one described above is referred to as a "call option." There are options to sell at a specified price instead of purchase, which is called a "put option," and provides profit when the cost of the good falls below the agreed upon price, allowing the option holder to exercise it and sell at a higher price than the market.
Financial engineers mix and match all of these derivatives—forwards, futures, call options, put options, and selling and buying options—to create exactly the conditions and amounts of profits desired by their clients. Some of these can become quite complicated. If you know what all the underlying derivatives do, you can work through and determine exactly what’s happening inside each of these arrangements.
Example: Olive Presses in Ancient Greece
An ancient Greek philosopher, Thales of Miletus, wanted to prove to his contemporaries that philosophy could be useful for more than just asking questions in the city square. He set out to find a way to prove this.
One year, anticipating a greater-than-expected olive harvest, he approached the owners of all the olive presses in town and made them this deal: "I'll pay you a small deposit now and, in exchange, I want the right, but not the obligation, to rent your presses during the harvest season at this agreed upon price."
The olive press owners agreed and, as Thales predicted, the harvest was especially good. Demand for olive presses was incredibly high, and the prices to rent them rose dramatically. Thales exercised his option, rented the presses at the agreed upon price, then turned around and rented those presses to the olive growers at a vastly inflated price.
Thales made a fortune and proved the usefulness of philosophy. Had the olive harvest been poor, Thales would only have been out his small deposit. He didn't have to pay the full rent unless it was going to be profitable for him. In other words, Thales had a call option. The first call option, in fact.
Related: 5 Reasons Why You Should Study Finance
Understanding the Differences between Forwards, Futures, and Options
Although forwards, futures, and options can appear to be similar upon first glance, there are important differences between each. Depending on key factors, like risk, there are different scenarios when each of these derivatives are most effective.
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This post was updated on September 9, 2019. It was originally published on November 9, 2017.
