The plain guide to derivatives

by Ned Swan

Introduction

The purpose of this paper is to explain simply and clearly, what derivatives are and how they can help reduce financial risk.

Ideally, I would like to accomplish these goals on one sheet of paper with one or two punchy illustrations. However, that is not going to happen. So, let's take it in easy steps and try to finish as quickly as we can.

Why derivatives?

All businesses need to plan. They need to be able to calculate, as closely as possible, what their future expenses and what their future revenues will be. Such calculations enable them to know how much plant to build, how many people to hire, what borrowings they can support and generally what plans they can afford to make.

It’s obvious that any business that won’t or can’t plan, is gambling with its future. That business is indulging in a naked speculation on what its future cash flow will be, and, indeed, on whether it will make a profit or go broke.

For example, during the last few years, those in the pulp and paper industries (and those that rely on them) have been indulging in just such speculation. In November of 1983, NBSK pulp, the industry standard grade, was £265 per tonne. In October 1984, it was up to £425. In late 1985, the price dived to £260. In late 1989, it was £535, but plunged to £280 by November 1991. In late 1995, the price was up to £640 but was back to £340 by May of 1996. These changes have been disastrous for producers and customers. Not even the most savy pulp and paper executives could predict pulp or paper prices, which meant that sensible business planning was out the window. No one could predict what pulp and paper would bring in revenues or what they would cost.

Every business dependent on pulp or paper: producers, buyers, sellers and users were all speculating on the rise and fall of pulp and paper prices. In many cases, they were betting their entire business on those price movements.

Wouldn’t they have all been happier if they had a mechanism that allowed them to plan those levels of prices? You can bet they would have.

Aren’t there any tools that allow businesses to plan to protect themselves against future price changes? Yes. Derivatives.

What is a derivative?

A derivative is the sale of a promise. That’s all it is.

One party (Derivative Buyer) buys from another (Derivative Seller) a promise that, at an agreed date in the future (1 month, 6 months, 1 year, 10 years, etc. from the date of the agreement), the Derivative Seller will deliver to the Derivative Buyer an agreed quantity of some asset the Derivative Buyer wants for a price agreed at the time the promise is made. In legal terms, this sale of a promise is called a "contract". 1

1 Even more precisely, a bilateral, executory contract

What about all the complexity we hear about?

A promise can be as simple or complex as you want to make it. You can buy a promise to deliver a cup of sugar in one month’s time for 2p. Or, if you want, you can buy a promise that in one year you will receive the value (paid in Java stone money) of the prime interest rate of the largest German bank (calculated in Italian lira), multiplied by the distance to the moon (in US miles) and divided by the price of oranges at the largest market in Tunisia at 8:51 AM on July 1, 1997 (in Polish zlotys). How simple a promise do you want to buy, or how complex? The choice is up to you.

The more complex a promise is, the more difficult it is to calculate its value because more components affect that value. Consequently, when the value of the promise sold is affected by a number of factors, the calculation necessary to determine its value (at any point between the time it is sold, and the time at which it is to be performed [in our example one year]) can exceed the capabilities of ordinary arithmetic and require the use of sophisticated statistical analysis or mathematical modelling. Not everyone can apply these mathematical tools. In the case of very complex promises, only those highly trained in mathematics would have the skills to know how to approach the problem of constructing a formula to describe the numerical relationship between the various components of the promise. 2 Among those highly trained mathematicians now being employed by banks and brokerage houses to calculate the values of the complex promises constituting some derivatives are people trained in physics, some with advanced degrees. This is why the people who make those calculations are sometimes called "Rocket Scientists." 3

2 Such a formula is called an "algorithm."

3 However, do not be misled by this flattering title. Those who are truly skilled at "rocket science" tend to work for NASA, not banks and brokers.

Instead of the silly example of a complex derivative given above, let’s take a real example. There is a financial house that sells to airlines a derivative for the price of jet fuel. Airlines, like other businesses, want to plan. They want to know how many planes they can afford to buy, how many staff to hire, how many routes to bid for, and how much profit they are likely to make from the seats that they sell to passengers. Airlines do not want to be in the business of speculating on the price of jet fuel. Price fluctuations in that commodity can bankrupt them.

Consequently, airlines are happy to buy promises that for 5, 10 or more years, they won’t have to pay more than a defined price range for jet fuel. If the price of jet fuel goes above the defined range, the derivative seller pays the price difference to the airline. If the price dips below the defined range, the airline pays the price difference to the seller.

From the airline’s side the elements of this promise are extremely simple. They have bought a promise that takes the speculation in jet fuel out of the equation of running an airline. They are now in a position to plan their expenditure for jet fuel and can use that knowledge to concentrate on making profits from selling seats to passengers.

From the derivative seller’s side, this promise is much more complex. The price of jet fuel over a ten year period is affected by a number of factors: the price of oil, the price of refined products, the price of transportation, the exchange rate of various currencies and other things. The seller, by selling the airline a promise to fix the price of jet fuel, is assuming the risks that the prices of any or all of those things could change unfavourably. How can the seller protect itself against those risks, so that it can safely plan its own future?

Just as the airline has protected itself against unforeseen changes in the price of jet fuel by purchasing a promise from the seller to compensate the airline for such price changes, the seller can go to various derivatives markets and purchase promises to fix its future exposure to price changes of various commodities. The seller can go to an energy exchange (such as the International Petroleum Exchange ("IPE") in London or the New York Mercantile Exchange ("NYMEX") in New York) to buy derivatives fixing the price of oil or refined products, it can go to a bank or a currency exchange (such as the International Monetary Market in Chicago) to fix the exchange rate for currency, it can go the a freight exchange (such as London’s Baltic Exchange) to buy a promise fixing the price of sea transport. In other words, the seller can also buy promises to protect it against the risks from price changes that it takes on by selling the jet-fuel promise to the airline.

The bottom line is that for both the seller and the airline, derivatives help them to plan to protect themselves against future price changes.

Why derivatives exchanges?

What’s the difference between buying private custom-made derivative promises from individual brokers, banks, or business partners and buying them on one of the many public exchanges in London, New York, Chicago, Tokyo, etc?

Risk. Different ways of buying derivatives have different risks.

Remember! A derivative is nothing more than the sale of a promise. Don’t ever forget that!

When you buy a derivative, you are only buying a promise to do something in the future. If the seller has promised to deliver 10,000 barrels of crude oil, you have not bought oil, you have only bought a promise to deliver oil. If the seller has promised to deliver fifty tonnes of pulp, you have not bought pulp, you have bought a promise to deliver pulp. If the seller has sold you a promise that you are paid a future stream of income or an amount of currency you have not purchased any money, you have only purchased a promise to receive money in the future.

In fact, the reason that derivatives are called "derivatives" is because the promise that is sold does not have an inherent value. The value of a derivative is "derived" from two important factors:

• the market value of the asset that is promised to be provided (such as crude oil, pulp, or currency); and
• the ability of the seller to deliver on his promise. 4

4 Of course, you may get money damages if a court finds that the promisor is liable for failure to deliver on this promise. However, such a judgment is no good to you if the seller is so broke that he doesn't have assets to enforce the judgment against.

The second is probably more important than the first, because if the seller can’t deliver the asset he has promised, it doesn’t matter what the value of the asset on the market is, because you are not going to get it.

As can be seen, one of the major risks of buying private, custom-made derivative promises from individual parties is that when the time comes for them to perform their promises, they might not be able to. You are then faced with the complicated and unpleasant task of trying to use the legal system to extract damages from them.

Another risk with custom-made derivatives is that if, during the life of the contract, you become persuaded that it is unfavourably moving against you, there is a risk that you will not be able to sell it to someone else because the contract is too particularly fashioned to meet the needs of a single company.

One way to reduce those risks is to trade on an established exchange. An exchange usually has many members (from a couple of dozen up to several thousand).

With exchange trading, the risks associated with custom-designed derivatives negotiated with individual brokers or banks 5 are diminished in two ways. First, exchange-trading is usually done with "standardised" contracts, all of which are identical with respect to the grade of the asset, its quantity and the permitted delivery terms. Of course, the length of the contracts or the times of delivery and the price can vary. This "sameness" makes it easier for purchasers to sell their derivative contracts back into the market if at some point during their life they become dissatisfied with them. 6 The ease of getting in and out of the market is also enhanced by the fact that an exchange usually has many members, some of whom are trading for their own accounts, some of whom are trading on behalf of clients, some of whom are doing both. This means that it is more likely that a large number of buyers and sellers are in the market on any given day than there would be in the case of a custom-negotiated derivative promise.

5 In the trade called "over-the-counter" sales of derivatives ("OTC").
6 In the trade, this is called "market liquidity".

Secondly, the risk of the other party going broke has also been diminished. Trading on exchanges is usually done in such a fashion that it is the exchange itself (or the clearing house organisation of the exchange) which is officially the opposite party in each transaction.

Usually exchange trades are "guaranteed" by a clearing house which is an organisation (either connected to an exchange or independent) that arranges for the performance of exchange-traded derivative contracts when the time for performance comes due and "guarantees" the performance of the contracts with its own financial resources. This means that if one of the parties to the transaction goes broke, the clearing house undertakes to make sure that the promise is performed.

A clearing house is usually underwritten by a cash and insurance guarantee of many millions to ensure that it will be in a financial position to make sure that performance occurs.

This spreads the risk of one party going broke among the many institutions that back an exchange and its clearing house. 7

7 This is not to say that all "performance risk" is eliminated, exchanges can run into financial difficulties too. However, it happens less frequently than individual companies having difficulties.

Essentially, buying a derivative is a matter of spreading your risk. Instead of an individual company bearing all the risk of future price changes of commodities itself, it has found a counterparty (or in the case of an exchange, many counterparties) to share those risks. For this sharing, of course, a company will pay a premium. The premium varies depending on the derivative offered, how long it is for, how volatile the price of the commodity has been in the past, what the demand is, but it is usually some small percentage of the face value of the contract, perhaps less than 1%, perhaps several per cent. 8

8 In the case of large volume financial futures contracts (such as derivatives designed to protect against interest rate fluctuations traded on the London International Financial Futures Exchange (LIFFE) cost to a high volume trader (such as a bank) is said to be around one "tick" (the trade term for the minimum price movement of the contract which is usually pegged at around one ten thousandth of the face value of the contract). With lower volume commodity-based contracts such as the cotton futures traded at the New York Cotton Exchange, the cost to a regular trader can be about $50.

However, although trading on exchanges does diminish several risks, it raises others. One risk is that the standardised, generic contracts traded on an exchange and designed to appeal to a broad cross-section of companies and institutions, may not precisely balance the kind of price risk that an individual company is facing. For example, a cotton trading company can purchase futures contracts to protect it against the price risk of cotton at the New York Cotton Exchange. However, those contracts are pegged to an American price (called the "Memphis" price). If that company in fact buys most of its cotton from Turkmenistan, the Memphis price may not give a good reflection of changes in the price of cotton produced in Turkmenistan. Consequently, there may be a substantial gap between movements of the price of cotton contracts at the New York Cotton Exchange and movements of the price of Turkmenistan cotton. In such cases, a cotton trader may be able to come up with a reasonable calculation about the relationship between the price of the cotton he buys and the price of the cotton traded at the NYSE. This may be sufficient to protect him. However, it may not. He may need a custom-designed contract, suitable for his own needs. In that case he would be better off buying a specially designed OTC contract from an individual broker or bank. It may cost more to buy, but the level of protection it gives may make this extra cost worthwhile.

In other words, although derivatives help a company manage its risk, they do not justify abdicating responsibility to determine how well those derivatives match needs. This has to be done by careful consideration of the same business criteria that enter into any other business decision. A company may already be doing this and already making those kinds of decisions. Most companies operating internationally today enter into derivative contracts to protect them against changes in the value of foreign currency against their home currency. These derivative promises are often called currency "forward" contracts which are entered into between companies and their banks (or brokers). As a result, most companies have a well-established risk management system when it comes to currency. There is little reason why procedures, methods and safeguards employed in managing that risk cannot be employed in managing the risk of other commodities, the prices of which have a substantial effect on the core businesses of the companies in question.

What about swaps and options, etc?

One hears, or reads in the paper, about all kinds of exotic-sounding financial instruments that seem to relate to derivatives, such as swaps, options, futures, forwards, and all their interesting varieties ("American options", "European options", "interest rate swaps", "commodity swaps").

It is true that there are a wide variety of promises that are sold to protect companies against particular risks that they are facing. However, don’t let the names get in the way of your understanding. They are just trade jargon to describe particular kinds of promises that are sold to protect against the risks of particular price changes.

There are three basic kinds of derivatives:

• the sale of a promise solely to deliver an asset in the future (whether it be oil, pulp, pork, oranges or French Francs), can be called a forward contract;
• the sale of a promise either to deliver a physical quantity of an asset or to pay its market value in the future can be called a futures contract;
• the sale of a promise solely to pay the market value of an asset in the future is called a contract for differences.

If you are not happy with the promise you have (such as to pay a fixed rate of interest) and trade it for one that suits your business needs better (a contract to pay a floating rate of interest), that trade is called a swap.

If you would rather not make an immediate commit-ment to buy a particular promise but wish to think about it, you can purchase a promise to let you think about it for a limited period of time called an option.

That is the whole world of derivatives, but there are many variations depending upon particular elements of the different promises sold. The things to focus on when you purchase a particular promise are the elements of the promise and how much you will pay for them. You should be making the careful business evaluation of the kind you would make when purchasing any product.

Won't derivatives make prices more volatile?

No. If anything, they will make prices less volatile.

One often reads about wild price swings in various commodities or currencies and how certain people (like George Soros) made huge amounts from trading derivatives connected with those swings. The difficulty with this kind of reporting is that it creates an impression that commodity price changes are the result of derivatives trading. Economists have examined this question for many decades and the general conclusion is that derivatives trading (even including all of the speculation that occurs in derivatives markets) helps decrease the extremes of price changes rather than increase them.

A couple of examples are useful. One of the most dramatic is the price of pulp over the last few years. That price has fluctuated up and down about 400%. There can be no clearer example of volatility. This was certainly not caused by derivatives trading. Until recently, no significant derivatives markets existed for pulp.

Commodity prices are fundamentally the result of supply and demand. A derivatives market for pulp, will not bring about the sudden creation of new pulp producers or new buyers. The buyers and sellers will be the same. Prices will be determined by their supplies and their demands.

A dramatic example of how little effect speculation has on commodity prices is shown by fluctuations in the value of the Pound Sterling in which George Soros is reputed to have made so much money. In that case, the British public financed what may have been the biggest failed market manipulation of all time. The attempt by the British government (and others) to support the value of Sterling within the ERM when the fundamental forces of supply and demand indicated it was overvalued. The government tried to battle against those forces of supply and demand by mounting a huge effort (some estimates have been as high as £30 billion) to change the tide of those forces. Not even the biggest manipulator of all time could do it and the value of the Sterling fell. Mr Soros made money because his speculation (in that case) was on the side of the forces of supply and demand and so he made a huge profit whereas the much bigger (and financially more powerful) British taxpayers lost a bomb. What this example shows is that in any reasonably free market (where the whole supply of a valuable commodity is not controlled by a few players), attempts at manipulation cannot resist forces of supply and demand. To try and do so is a way to lose a lot of money.

There are a couple of important ways in which derivative markets reduce price volatility. The first has to do with information. As stated above, every business needs to plan, any business is able to plan more effectively when it has more accurate market information in its possession. In many markets information about what is really going on in terms of purchases, sales and market prices, is hard to come by. This makes solid planning more difficult and tends to cause people to buy on the basis of rumour, speculation and unsupported fears. Such motivations can cause wilder price gyrations than solid market information.

Derivative markets are an aid to closing the information gap. They can, especially in the case of exchange-traded derivatives, provide an open publicly-reported account of trading in valuable assets on a daily basis. This gives the entire market a picture of what traders think assets are worth today and what they think they will be worth in the future. Prices showing trades of immediately available assets 10 and prices of the trading of promises to deliver in the future are all reported. This gives you a consistently reported and up-dated view of what the market thinks of as a likely movement of asset prices. This tends to diminish peoples’ reliance on unsupported rumours and fears and tends to help them regularise their buying patterns and gives them the confidence to enter into more transactions for future delivery. The overall effect of these things is to smooth out the highs and lows that can occur in markets where less information is available. The second way is that having a publicly accessible market to trade promises for the delivery of assets brings more buyers and sellers into the market. Greater information available about markets where derivatives are traded gives more people confidence to purchase promises that reflect their view of what is going to happen in the future. Some of these people are involved in trades directly related to the promises (as producers, traders or users of the underlying commodity), some are what are called "speculators". The increase in this population of potential traders brings more people into the market to express their views (by purchasing derivative contracts) about the value of present and future assets. This makes prices a more accurate reflection of supply and demand and, again, tends to smooth out price gyrations.

10 Called in the trade "spot" trading.

It is worth taking a minute here to talk about the role of speculators, because they are important to any market. In derivative markets, there are two kinds of basic traders. The first are called "hedgers". Hedgers are those parties that have an existing business connection with the assets that underlie the derivative promises being bought and sold. For example, in the case of pulp, there may be pulp producers, pulp traders, or pulp buyers. Their businesses are directly affected by variations in the price of pulp. They go into the market to stabilise their relationship to those prices by buying and selling promises that balance the risks they are taking in their physical business (an example of how this can work will be given below). They are coming into the derivatives market to reduce their risk rather than to take on more.

Speculators are different. They have no inherent relationship to the assets that underlie the promises. What they have is a "hunch" that the price is going to go up or down. They purchase contracts to back that hunch. When they enter the market they are doing it to take on more risk. They take on risks by purchasing promises relating to the price of assets in which they have otherwise no interest. From whom are they purchasing this risk? THE HEDGERS.

This should make the value of speculators obvious. They are buying, and assuming for themselves, some of the market risk that would otherwise be borne by the hedgers. In other words, they are coming into the market and allowing hedgers to get rid of their risk by selling that risk to speculators who are happy to take it on because it conforms to their view of which way the market is moving. Speculators are helping to bear the burden of business risk. Their contribution should not be underrated.

Derivative markets offer you access to a pool of people who are willing to put up their own money to help you bear the risks of your business. This gives you many more options outside of having kindly rich relatives. The fact that speculators hope to make money from helping you out shouldn’t be looked down upon.

Aren't there other methods for protecting against price changes?

In the past, methods for protecting against other price changes were available. Most important of these consisted of cartels and monopolies, price support agreements and central government planning. If you don’t need to protect against unforeseen future price changes, you don’t need derivatives. If you have a monopoly on a commodity, or if you and your pals are getting together to set prices between yourselves (and you collectively control a significant portion of the market), you don’t need to use derivatives as a planning tool against future price changes. You know what future prices are going to be.

Price support agreements have the same effect. If you know prices are not going to fall below a certain level, what do you need derivatives for?

In many countries, in the recent past, prices were determined by central government planning. In those countries, derivatives had no place, because the government told you what future prices were going to be. You could do nothing to protect yourself against those changes.

As should be obvious, almost all of those methods of protecting against future price changes have now become unavailable. Legislation has made monopolies and cartels difficult (and potentially expensive) to operate. Price support agreements have collapsed because no group of producing countries is powerful enough to resist forces of supply and demand. If they try, eventually they go broke.

Communism and other central planning mechanisms have largely collapsed, because they proved, in a relatively short time, that even enormous and resource-rich countries cannot resist the forces of supply and demand and if they try to do so, they go bankrupt.

In the modern economy, the only sensible alternative is to take the market opportunity to protect yourself against changes in future prices by purchasing derivatives.

What about long term-contracts?

Long-term contracts can be useful, but in times of price volatility they are very hard to get and to operate. Businesses know that they need to plan, so when they don’t have an accurate idea of what future prices are, they are reluctant to enter into long-term contracts. Even when long-term contracts can be obtained, powerful businesses will "renegotiate" those contracts when prices change if they have the economic power to force their suppliers to do so.

Both these problems have arisen recently in the pulp and paper industries. Whereas in the past it was possible to get long-term contracts, in the midst of the price volatility of recent years, companies have been increasingly reluctant to enter into them and more powerful members of the markets have renegotiated those contracts when they thought that better prices could be obtained.

An even more basic problem with long-term contracts is that they are a one way bet. Once you enter into the contract, you have made your bet on which way prices are going to move. If you are wrong, you can take a bath. You don’t have much flexibility.

The advantage of derivative markets is that they offer continuous trading in promises related to future assets. If you see the market moving against you, you may have an opportunity to sell your contract back into the market, cut your losses, enter into a new contract and change your position with respect to market movements. This gives you a much higher degree of flexibility to change your position and protect yourself against changing price movements than a long-term contract.

Derivative markets give you a flexibility that is not otherwise available.

Example

Perhaps the best way to see how a derivative might work is to take a concrete example. The purpose of the example is to show how derivatives help improve a company’s ability to plan, by stabilising its relationship to price changes.

As a practical example of how this works, we can use the NYMEX electricity futures contract to demonstrate.

Suppose on November 1, a Producer of electricity anticipates that it will sell 736 megawatt hours in February (in the cash market) at $16.00 per megawatt hour. Its potential revenue from that sale would be $11,776. The Producer’s current cost of product is $14.00 a megawatt hour and the Producer does not foresee that will change. However, the Producer is worried about a price decline, so it is worried about entering into a firm contract for February. For example, if the market price of electricity fell to $12.00 a mega-watt hour, the Producer could suffer a substantial loss.

The Producer can "stabilise" its relationship with the price by going into the futures market and selling one NYMEX electricity futures contract for February delivery at $16.00. Its revenue from that contract is $11,776.

By January 17th, cash market prices have fallen to $13.00 a megawatt hour. As anticipated, the Producer sells for February physical delivery at the cash market price of $13.00 a megawatt hour. His revenue is $9,568 which is $2,208 less than he expected. however, he can now buy back his NYMEX futures contract at $13.00 a megawatt hour. His total cost of that purchase is $9,568. Deducting that from the $11,776 he realised from his previous sale of that contract, he has made a profit of $2,208. This makes up for the loss he suffered in the cash market which means that his total revenue on the two transactions is $11,776. This is the same amount he expected to earn back in November. In other words, the Producer "stabilised" his relationship to the market. The device he used is called a "shorthedge" which is a protection against price decline.

But what happens to the Producer if prices rise? If on January 27, the cash market price has risen to $17.00 a megawatt hour it will cost the Producer $12,512 to buy back his NYMEX futures contract. This is $736 more than expected. However he will be able to sell electricity for February physical delivery in the cash market at $17.00 a megawatt hour. This provides the Producer with a revenue of $12,512. This is $736 more than expected. In other words, he will have lost $736 on the NYMEX futures contract but gained $736 in the cash market. This loss and gain cancel each other out which gives the Producer a total revenue of $11,776, as he expected in November. Again, he has used the futures contract to "stabilise" his relationship to the price of electricity.

Of course, a consumer of electricity can use the opposite strategy to "stabilise" his relationship to the price. These examples are, of course, a simplification, but they do demonstrate the effectiveness of hedging with derivative contracts.

The significance of derivatives

As can be seen, the company in our example has traded its uncertain speculation on the price of electricity for the opportunity to make a reasonable profit. This has greatly enhanced its ability to plan.

The example above can be applied to any other commodity whether it be oranges, crude oil or US Dollars.

The importance of this price protection to any international business is shown by the fact that derivatives is now the world's biggest business by far. The average daily turnover in derivatives is calculated by the Bank for International Settlements to be equal to more than US$2 trillion per day. As stated before, all international businesses need to hedge themselves against future currency exchange rate prices, so most of these transactions are in currency but they do include a wide range of commodities. The size of this market is an indication of how important planning is to most major industries.

To be able to plan for the future and to compete effectively in the global economy, every major industry needs to take full advantage of derivatives in order to enhance its planning and to protect itself against unforeseen price fluctuations.