- Derivative Securities and Derivative Markets
We explain the derivatives market in this chapter. Up to this point, we assumed all
transactions were spot transactions. Buyers and sellers exchange money and the financial
instrument immediately. In a derivatives market, investors can buy and sell contracts today that
specify future purchases of financial securities and commodities. This chapter explains the
derivative forms: futures and options contracts, credit default swaps, and currency swaps.
Finally, we distinguish the role between hedging and speculation. Although derivative contracts
allow investors to protect themselves from future price volatility, speculators can buy and sell
derivatives to earn large profits or suffer massive losses.
Forward and Spot Transactions
Financial derivatives received bad publicity from infamous bankruptcies during the 1990s
and from the 2008 Financial Crisis. In 1995, Orange County, California, experienced the largest
bankruptcy for a municipal government with losses nearly $2 billion. Press concentrated on
derivatives as the cause of the bankruptcy, but the fund manager made poor decisions. Another
famous case was Barings PLC. Barings was a London investment firm that was founded in
- One trader, Nick Leeson, lost roughly $1.3 billion in the derivatives market, bankrupting
Barings. Finally, commercial and investment banks created a variety of new securities, called
Credit Default Swaps (CDS) that played a role in the 2008 Financial Crisis. CDS is similar to
insurance for investors. The 2008 Financial Crisis created hardship on many financial firms and
investment banks. These institutions guaranteed payment on pools of mortgages that
bankrupted. Thus, these firms paid billions of dollars in payouts to honor these CDS contracts.
We discuss CDS contracts in this chapter.
Derivatives are a contract, a piece of paper. Farmers and merchants invented derivatives in
the Middle Ages to protect themselves from price fluctuations. Buyers and sellers agree to a
price today, but they exchange the good for money at a future date. Financial derivatives protect
investors from price uncertainty. Previous chapters focused on spot transactions, where a buyer
and seller complete a transaction by immediately exchanging money for the commodity.
However, forward transactions delay the exchange of money and assets to a future date. For
example, a bread company needs six tons of flour in six months. Many things could occur
within six months. A drought causes the wheat’s price to soar, or heavy rains could cause a
bumper crop, causing the wheat’s price to plummet. Bread company wants to protect itself from
fluctuating prices. Consequently, the bread company enters into contracts with wheat farmers,
where the bread company and farmers negotiate a price of wheat today. However, the bread
company will pay the farmers for the wheat when the farmers harvest the wheat six months from
now. Contract protects both the bread company and farmers from price fluctuations.
Price of derivatives receives or "derives" their value from the underlying assets. Assets
could be commodities such as coffee, corn, petroleum, pork bellies, and wheat, or financial
assets such as stocks, bonds, currencies, Eurodollars, and other financial instruments.