A derivative is an asset whose value is based on a different underlying asset. They are called derivatives because they derive their value based on the value of something else. That something else is called the “underlying asset” and can be any asset, such as a stock/ share in a company, land, bags of grain, plant and machinery, inventory, or any other asset, group of assets, or even a benchmark1, or a variable, such as the weather, or an event (outcome of an election). If something has an associated measurement that can be reliably quantified, it can be the “underlying asset”. The underlying asset is also called the “Primary Instrument”.1
If there is any uncertainty about what the value of the underlying will be in the future, whether it is the price of a house, the earnings of a film, or how much rainfall there will be in the month of July next year, there can be a derivative about it. This is because derivatives are based on risk- some parties wish to protect themselves from a particular risk they foresee, and others believe that risk is worth taking. A derivative is a transaction between such risk averse/ risk protective and risk friendly parties.
Why do some people wish to take on more risk while others avoid it? Because humans have different opinions about what will happen in the future, generally believe they are correct about their assessments, and have varying risk appetites. Those with higher risk appetites may think of derivatives either as a wager, or a bet, and those with lower risk appetites may look at them as insurance or hedging against risk.
When thinking of derivatives as wagers or bets, we can liken them to sports betting, and just like organisations that run bets on sports matches have books of odds of what they think the result is likely to be, weather derivatives have an “index” of what is the normal or average or expected weather for a particular geography at a particular time of the year, and how likely it is to be that kind of weather. This is also called speculation- we are speculating on what the associated value measurement of the primary instrument will be at some point in the future, or, we are making a bet or a wager that it will be a particular value, but their value in climate finance lies in the security they provide against weather abnormalities. For example, both less and more rainfall than expected can be negative outcomes for farmers as both can ruin their crop. This sounds like an insurance, except that insurances pay out only when all their conditions are met- derivatives pay out when there is any deviation of the value of the underlying asset from what it was supposed, or expected, to be (the average value).
This is how derivatives can be used instead of insurance, and also why they are often considered better than insurance for those who know how to use them- insurance firms pay out only if there is evidence of a loss, and the loss must be proven to their standards, and even so your entire amount may not be covered due to contractual issues or because they don’t cover certain common types of losses, or even because the insurance company does not consider the evidence you provide to be sufficient. A derivative will pay out immediately as long as there is a difference between what was supposed to happen according to the contract, and what actually happened.
There are two general types of derivatives- firm commitments, and contingent claims. If parties participate in a firm commitment, that is, they promise, they must then fulfill the promise and complete the contract. For contingent claims, you have the option to follow through or not at the time the contract becomes due.
Because the value or price of the primary asset on which the derivative is based can move upwards or downwards, derivatives can also be thought of as being based on the direction of this movement. This is why some contracts are called “long” and some are called “short”:
Long contracts- you will benefit if the value of the underlying asset increases in the future. In case of sports for a match between Teams A and B for Team A to win, you are long (bullish) or you are long on Team A’s chances to win (winning being considered positive, generally).
Short contracts- You will benefit if the value of the underlying asset decreases in the future. In the case of the sports teams, since you are expecting Team A’s victory to take place, you will be short on Team B, because you expect their loss to take place or their value to decrease after the given match.
Example: Let’s say you come to know that Company X will purchase Company Y in the future, you are likely to purchase more shares of Company Y, because usually the purchasee is overvalued by the purchasing company, therefore the price of the shares of Y will increase since X is likely (via historical evidence) to have paid more for Y than Y is actually worth. Simultaneously X’s value is likely to reduce in the future because they have paid more than they should have. You are therefore long on Y and short on X.
Types of derivatives:
Futures
A Futures contract is an agreement to buy or sell an underlying asset at a future date and price that are both set down in the contract.
Futures contracts are standardised, and the counterparty is always the exchange it is traded on- this means, the entities buying or selling the contract do not have contact with the party selling or buying (respectively) the contract. Each party only interacts with the exchange on which the trade is taking place. Because they are exchange traded, the contracts are standardised rather than personalised.
These contracts are also settled daily by the exchange with the involved parties, so if the buying price of the contract increases, the exchange will ask the purchasing party to top up the difference, further discouraging rogue traders. Further, since these contracts are standardised and exchange traded, they are liquid and transparent.
Example: A natural dye trader worried that her crop of marigolds has not yielded enough flowers in time to make the dye for her next shipment due. She decides to purchase a futures contract for a few additional caseloads of fresh marigold petals, thinking that it’s okay if she ends up with more golden dye rather than less of it.
The contract states that two weeks from the date of purchase, the purchaser of the contract will pay the USD 150 for two kilos of fresh marigold petals. Now the farmer is certain that weather her farm produces enough marigold or not, she will have ready to use fresh petals for making her dye.
Let’s assume that on the date of delivery the price of two kilos of fresh marigold petals is USD 140 in the market, then the farmer still has to pay USD 150 for her delivery. And vice versa.
Forward
A Forward contract is similar to a Futures Contract, with the sole difference that these are customised private contracts between two parties rather than exchange traded.
Therefore these are not centrally settled, they are not liquid, and there is a possibility that the counterparty, which is the other trader and not a central exchange, may renounce the contract at any point, leaving the other party hanging.
Example: Morgan and Akanksha enter into a contract with each other to buy and sell 10 crayons of the now discontinued Crayola Daffodil Yellow. These are not available in the market any longer, and Akanksha is the only seller available, so she can decide any terms. This is also a very small quantity of product and an unusual product for the commodity markets. Morgan and Akanksha therefore enter into a Forward contract to accomodate all the unstandardised elements of their exchange.
If either party were to decide to dishonour the contract at any time before the exchange is completed, there would be no penalties exacted upon them, and the contract would fall through.
Options
Options, give people the possibility of doing something in the future. There are two kinds of options: A Put option, and a Call option.
A Put option is the right, but not the obligation (that is, the option), to sell an underlying asset in the future at a certain price which will be decided at the time of the contract.
A call is the right, but not the obligation, to purchase an underlying asset in the future at a certain price which will be decided at the time of the contract.
Example: A restaurant does not know how many tourists the city will host next year. Depending on whether more than expected tourists come, the owners of the restaurant wish to secure their supply of onions for their famous French onion soup. If there are more tourists, there will be more demand for onions, and then their prices will increase- and yet, the restaurant cannot always increase the price of the soup to reflect the increased price of the onions.
To secure their future supply, and to save themselves price uncertainty, they buy the option to buy more onions during tourist season at current prices. Now they are assured that if prices increase, or supply is tight, they will still have access to the produce. In case at the specified time the option can be exercised, the price of onions drops, they can always just buy from the market, and their only loss is a small fee paid to purchase the option, which for the restaurant is a call option.
If the market price of onions is higher than the price they agreed to pay as part of the Call Option they have bought (that is, they bought the option to buy onions), the restaurant can buy at the Call price and save money in comparison to what they would have paid for buying onions off the open market.
If the market price is less than the call price, they can just buy from the market and the only money they lose is the small amount they paid to buy the Call Option.
Example: For a Put Option, think of a scuba diving instructor, whose business is weather dependent, buys the Option to sell his lessons to a cruise shipping company. This is a Put Option, because it is the option to sell. If during the given week, the weather is good, the scuba diving instructor can sell his lessons at a higher price to other tourists and make more money. However if the weather is poor and tourists do not wish to go scuba diving, he can still sell to the cruise ship company.
Swaps
Swaps allow us to exchange cashflows.
Certain types of financial contract result in a stream of cashflows. For example, a debt contract results in a stream of interest income. Parties can agree to swap the interest they will receive (or pay) in the future with each other.
Example: In terms of climate financing, think of a weather dependent business, for example a movie shooting outdoors. The film production house can get into a Swap contract with a financing company. Let’s say the film company requires 20 continuous days of sunshine and warm weather at their location. They can get into a Swap Contract that says they require an average of 10 hours of sunshine daily, and another Swap that says they want an average of 25°C temperature daily for the twenty days of their shoot.
If the weather is different over the time period for which the film producing company bought the derivatives, they will automatically be paid (just by comparing the actual weather to the base index) and can use the money to cover additional costs that were incurred due to the different weather (like it was rainy instead of sunny).
So, a film production company (Party A) and a financial institution (Party B) enter into a weather swap that says that if there is more than 0 cm of rain between June 20 and July 10 at their location, Party B will pay $10,000 per day where there is more than 0 cm of rain to Party A.
Weather Swaps are generally two way contracts, so depending on the contract, perhaps if there are no rain disruptions, the Production Company may pay the financial institution $10,000 x 20 days = $200,000 instead. This depends on the contract they have entered into.
Sources
Chasing Tales 