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I haven't been able to find exactly what a derivative means. It seems to be some sort of cross of insurance, stock, and lay-a-way. When I try to look it up, all I find is all the problems not regulating it has caused.

My question is:

  • What is the basic idea and concept behind a derivative? (This is my main question.)
  • How is it really used, and how does this deviate from the first point? Briefly, how does is it affecting people, and how is it causing problems?
  • What is some of the terminology in relation to derivatives (and there meanings of course)?
  • How would someone get started dealing in derivatives (I'm playing a realistic stock market simulation, so it doesn't matter if your answer to this costs me money (indeed, I've made it a personal goal to somehow lose every last cent of my money))?
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    Googling for "derivative investment" provides many useful links, including Investopedia and Wikipedia. Can you explain more specifically what you still don't understand after reading those descriptions? – BrenBarn Sep 11 '15 at 17:14
  • @BrenBarn The articles made more sense after reading the answers below. – PyRulez Sep 11 '15 at 20:52
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    @PyRulez Derivatives and modern finance are surprisingly old (IIRC well over 250 years) which implies that you will find many discrepancies in the usage of terminology bound to it. Usage might be quite quite uniform in the US (I do not know, just a supposition) but if you go international, then you will find that some countries or some companies use a more or less specific terminology. So the best thing you can do is focus on the core concepts and understand them well enough, because focusing on terminology will always sent you from contradiction to contradiction. – Michael Le Barbier Grünewald Sep 12 '15 at 7:54
  • @MichaelGrünewald I didn't realize. – PyRulez Sep 12 '15 at 11:45
  • In gambling terms, derivatives are side bets. – keshlam Sep 13 '15 at 3:13
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The basic idea behind a derivative is very simple actually. It is a contract where the final value depends on (is derived from) the value of something else. Stock, for instance, is not a derivative because the contract itself is actually ownership of part of a company. Whereas car insurance is a derivative because the payout depends on the value of something else namely your (and other peoples') cars.

The problem with such a simple definition is that it covers such a broad class. It covers simple contracts like Futures where the end value just depends on the price of something on a future date. But it extends to contracts complicated enough that people in finance call them Exotics.

Derivatives are broadly used for two things reducing risk (sometimes called insurance) and speculation. A farmer can use derivatives to make sure she gets paid a certain amount for her corn. A banker can group a bunch of loans together and sell slices to reduce the pain of a particular loan failing. At the same time people can use the same instruments to speculate on the price of (for example) that corn or those loans and the main advantage is that they don't have to buy the corn or loans directly. Any farmer will tell you corn can be very expensive to store.

Derivatives generally cause problems both individually and sometimes world wide when people don't properly understand the risks involved. The most famous example being Mortgage-backed Securities and the recent Great Recession. You can start understand the instruments and their risks by this wonderful Wikipedia article and later perhaps a used collection of CFA books which cover derivatives in great detail.

Edit: Michael Grünewald mentioned Hull's text on derivatives a wonderful middle ground between Wikipedia and the CFA books that I can't believe I didn't think about myself.

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    So if farmer Bob wants to make a derivative, he makes a coupon saying "100 bushels of Farmer Bob's corn on the 31st of november, 2015". Then he sells this coupon to Alice, how trades it at will. It called a derivative, because the value of the coupon is derived from the value of farmer Bob's corn. Am I correct? – PyRulez Sep 11 '15 at 20:09
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    Well not really a coupon and a LOT more legal stuff in there but you're getting the correct idea ;) – Ross Sep 11 '15 at 20:26
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    Yes coupons have to do with bonds. Unless he was going to pay her interest for buying the derivative; then maybe - but not an expert on bonds or coupons. As for when she pays it depends on the derivative also. You can think of derivatives as legal contracts. In fact more legal people work on creating derivatives than finance people. – Ross Sep 11 '15 at 20:41
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    @PyRulez Very close. It would work like "Delivery of 5000 bushels of corn (yellow number 2, substitutions at discount) on the 16th of December 2015 at $3.87 per bushel". The most important part is the contract fixes a price now so the farmer has a guarantee. However, in the end even though the farmers price is now fixed the contract (derivative) made/lost money depending on the actual value of corn on Dec. 16th. – rhaskett Sep 11 '15 at 23:29
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    @rhaskett Okay, and what if Alice gives it to Eve, who has no money? Does Alice get in trouble, or does is Bob out of luck? – PyRulez Sep 11 '15 at 23:38
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A derivative is a financial instrument of a special kind, the kind “whose price depends on, or is derived from, another asset”. This definition is from John Hull, Options, Futures and Other Derivatives – a book definitely worth to own if you are curious about this, you can easily find old copies for a few dollars.

The first point is that a derivative is a financial instrument, like credits, or insurances, the second point is that its price depends closely from the price of something else, the mentioned asset. In most cases derivatives can be understood as financial insurances against some risk bound to the asset.

In the sequel I give a small list of derivatives and highlight the assets and the risk they can be bound to. And first, let me point out that the definition is (marginally) wrong because some derivatives depend on things which are not assets, nor do they have a price, like temperature, sunlight, or even your own life in the case of mortgages. But before going in this list, let me go through the remaining points of your question.

What is the basic idea and concept behind a derivative?

As already noted, in most cases, a derivative can be understood as a financial insurance compensating from a risk of some sort. In a classical insurance contract, one party of the contract is an insurance company, but in the broader case of a derivative, that counterparty can be pretty anything: an insurance, a bank, a government, a large company, and most probably market makers.

How is it really used, and how does this deviate from the first point? Briefly, how does is it affecting people, and how is it causing problems?

An important point with derivatives is that it can be arbitrarily complicated to compute their prices. Actually what is hidden in the attempt of giving a definition for derivatives, is that they are products whose price Y is a measurable function of one or several random variables X_1, X_2, … X_n on which we can use the theory of arbitrage pricing to get hints on the actual price Y of the asset – this is what the depends on means in technical terms. In the most favorable case, we obtain an easy formula linking Y to the X_is which tells us what is the price of our financial instrument. But in practice, it can be very difficult, if at all possible, to determine a price for derivatives. This has two implications:

  • Persons possessing sophisticated techniques to compute the price of derivatives have a strategic advantage on derivatives market, in comparison to less advanced actors on the market.

  • Organisation owning assets they cannot price cannot compute their bilan anymore, so that they cannot know for sure their financial situation. They are somehow playing roulette.

But wait, if derivatives are insurances they should help to mitigate some financial risk, which precisely means that they should help their owners to more accurately see their financial situation! How is this not a contradiction?

Some persons with sophisticated techniques to compute the price of derivatives are actually selling complicated derivatives to less knowledgeable persons. For instance, many communes in France and Germany have contracted credits whose reimbursements have a fixed interest part, like in a classical credit, and a variable interest part whose rate is computed against a complicated formula involving the value of the Swiss frank at each quarter starting from the inception of the credit. (So, for a 25 years running credit of theis type, the price Y of the credit at its inception depends on 100 Xs, which are the uncertain prices for the Swiss frank each quarter of the 25 next years.) Some of these communes can be quite small, with 5.000 inhabitants, and needless to say, do not have the required expertise to analyse the risks bound to such instruments, which in that special case led the court call the credit a swindling and to cancel the credit. But what chain of events leads a 5.000 inhabitants city in France to own a credit whose reimbursements depends on the Swiss frank? After the credit crunch in 2007 and the fall of Lehman Brothers in 2008, it has begun to be very hard to organise funding, which basically means to conclude credits running long in time on large amounts of money. So, the municipality needs a 25 years credit of 10.000.000 EUROS and goes to its communal bank. The communal bank has hundreds or thousands of municipalities looking for credits and needs itself a financing. So the communal bank goes to one of the five largest financial institutions in the world, which insists on selling a huge credit whose reimbursements have a variable part depending on hundred of values the Swiss frank will have in the 25 next years. Since the the big bank has better computation techniques than the small bank it makes a big profit. Since the small bank has no idea, how to compute the correct price of the credit it bought, it cuts this in pieces and sell it in the same form to the various communes it works with. If we were to attribute this kind of intentions to the largest five banks, we could ask about the possibility that they designed the credit to take advantage of the primitive evaluation methods of the small bank. We could also ask if they organised a cartel to force communal banks to buy their bermudean snowballs. And we could also ask, if they are so influent that they eventually can manipulate the Swiss frank to secure an even higher profit. But I will not go into this. To the best of my understanding, the subprime crisis is a play along the same plot, with different actors, but I know this latter subject only by what I could read in French newspapers.

So much for the “How is it causing problems?” part.

What is some of the terminology in relation to derivatives (and there meanings of course)?

Answering this question is basically the purpose of the 7 first chapters of the book by Hull, along with deriving some important mathematical principles. And I will not copy these seven chapters here!

How would someone get started dealing in derivatives (I'm playing a realistic stock market simulation, so it doesn't matter if your answer to this costs me money)?

If you ask the question, I understand that you are not a professional, so that your are actually trying to become the one that has money and zero knowledge in the play I outlined above. I would recommand not doing this. That said, if you have a good mathematical background and can program well, once you are confindent with the books of Hull and Joshi, you can have fun implementing various market models and implementing trading strategies. Once you are confident with this, you can also read the articles on quantitative finance on arXiv.org. And once you are done with this, you can decide for yourself if you want to play the same market as the guys writing these articles. (And yes, even for the simplest options, they have better models than you have and will systematically outperform you in the long run, even if some random successes will give you the feeling that you do well and could do better.)

(indeed, I've made it a personal goal to somehow lose every last cent of my money)

You know your weapons! :)


Derivatives teratology

Future contract

Two parties agree today on a price for one to deliver a commodity to the other at some future instant. This is a classical future contract, it can be modified in every imaginable way, usually by embedding options. For instance one party could have the option to choose between different delivery points or delivery days.

Option

Two parties write today a contract allowing the one party to buy at some future time a commodity to the the second party. The price is written today, as part of the contract. (There is the corresponding option entitling the owner to sell something.) Unlike the future contract, only one party can be obliged to do something, the other jas a right but no obligation.

If you buy and option, your are buying some sort of insurance against a change of price on some asset.

Credit

This is the most familiar to anybody. Credits can come in many different flavours, especially the formula to compute interests, or also embed options. Common options are early settlement options or restructuration options.

While this is not completely inutitive, the credit works like an insurance. This is most easily understood from the side of the organisation lending the money, that speculates that the ratio of creanciers going bankrupt will be low enough for her to make profit, just like a fire insurance company speculates that the ratio of fire accidents will be low enough for her to make a profit.

Credit insurances

This is like a mortgage on a financial institution. Two parties agree that one will recive an upfront today and give a compensation to the second one if some third party defaults.

Here this is an explicit insurance against the unfortuante event, where a creancier goes bankrupt.

Electricity derivatives

One finds here more or less standard options on electricity. But electricity have delicious particularities as it can practically not be stored, and fallout is also (usually) avoided.

As for classical options, these are insurances against price moves.

Swaps

A swap is like two complementary credits on the same amount of money, so that it ends up in the two parties not actually exchanging the credit nominal and only paying interest one to the other — which makes only sense if these interests are computed with different formulas.

Typical example are fixed rate vs. EURIBOR on some given maturity, which we interpret as an insurance against fluctuations of the EURIBOR, or a fixed rate vs. the exchange ratio between two currencies, which we interpret as an insurance against the two currencies decorrelating.

Swaps are the richest and the most generic category of financial derivatives. The off-the-counter market features very imaginative, very customised insurance products.

Weather derivatives

The most basic form is the insurance against drought, but you can image different dangers, and once you have it you can put it in options, in a swap, etc. For instance, a restaurant with a terrasse could enter in a weather insurance, paying each year a fixed amount of money and becoming in return an amount of money based on the amount of rainy day in a year.

Others

Actually, this list is virtually without limits!

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A derivative in finance is simply any asset whose value is based on the value of another asset or based on the value of a group of assets.

A derivative contract is a type of contract (usually a 'standardized contract') with specific payout instruction based on the price changes of a different asset.

The basic idea is that it becomes easier to make a claim to an asset or property (and profit from this claim), without needing to physically transfer it (or even the title to said asset), and use much less capital to do so (reduce risk).

They become problematic when multiple people may have claims to the real asset, or when the value of the derivatives changes very quickly or are hard to calculate. There are also liquidity problems the further you get from the real asset. This is not a problem for all kinds of derivatives contracts. And you must recognize that derivatives are used colloquially in a way that has nothing to do with reality to cause fear in people/investors that are not financially savvy.

Many derivatives also have dubious or no economic purposes such that regulators don't allow them to be traded since they can't see how it is different from gambling. This is seen in financial markets that are less liberalized or cultures with puritanical backgrounds. Typically the trick is to convince regulators that the derivative or financial product helps with reducing risk and hedging and it will get approved.

I've mentioned some terminology, but this depends specifically on what kind of derivatives contract you become interested in. Swaps, Credit Default Swaps, Futures, Options, Options on Futures, Leveraged Exchange Traded Funds, Inverse Leveraged Exchange Traded Funds, warrants, and more all have their own terminology.

How to trade them in a simulation? It all depends on which financial product you really become interested in.

  • I don't understand the example: "The S&P 500 index is derived from the value of all 500 companies in the index. The S&P 500 is a derivative.". 1 share of SPY is an equity share in a unit investment trust, that has a price set by the last trade in the market, which could diverge from the aggregate price of the shares held by SPY. It's not a "derivative". The reported value of the S&P 500 index is a "statistic". – user662852 Sep 11 '15 at 19:26
  • Yeah that is a bad example - and should be removed. SPY (SPDR S&P 500 ETF Trust) however is a derivative. It's value is not from supply and demand of the underlying ETF itself but is set by the ETF trust to mimic the index. The index however is not a derivative its just an index. – Ross Sep 11 '15 at 19:52
  • @user662852 I never mentioned SPY that is a fund and that isn't what the comment was about. If there are problems with the semantics to my comment, then the S&P 500 index can be traded with cash settled contracts where nothing is delivered except cash based on the performance of the S&P, those are the derivatives. – CQM Sep 11 '15 at 23:06
  • The S&P 500 is a derivative. It is not; it is just an index. – Ross Sep 14 '15 at 12:54
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    @Ross I changed it. I was pointing out how its value was derived from other assets, as a contrast from tradable financial derivatives, but alright. Enough people got hung up on that to ignore the rest. – CQM Sep 14 '15 at 18:04
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There are a few unsavory factors that have led to the creation of new derivatives:

  • Cheating on taxes. If your accountants can create derivatives that are too confusing for the the revenue service's accountants to figure out, you can generate artificial or illusory losses in high-tax jurisdictions, offset by gains in low-tax jurisdictions.
  • Tricking your investors/trading partners/regulators. Derivatives are good at hiding either profits or losses, depending on what you want to conceal. This is euphemistically called "earnings management". This was the main way that Enron's fraud worked: they'd create phantom assets, and then use those as evidence of creditworthiness so they could take out more loans and/or engage in more risky trading.
  • Why the downvotes? Granted I did not answer the whole question, but I did answer part of the question that was not answered by anyone else -- "How is it really used". The illegal uses are an important part of the historical context of derivatives. – Snowbody Sep 16 '15 at 13:23

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