Derivation of a Derivative
Derivatives are headline financial news in times of market volatility and can seem very complicated. It may feel like this
type of investment is in the air somewhere floating around in the markets.
Stocks prices are reported and traded on an exchange and can be seen by all. Derivatives are traded over the counter or
just between the buyer and seller. This makes it difficult to see what derivatives are being bought and sold.
The first derivatives were created for the farmer. Since crop production each year is not stable, the farmer needs a way to
sign a contract with the buyer to be paid so much for this crop when it is harvested whether the corn, wheat, soybeans,
etc. are plentiful or scarce. This seems like a rational way to allow the farmer to survive the up and down years. This
agreement is called a futures contract.
Futures contracts have gone beyond the original purpose of guaranteeing prices at a certain time for agricultural products
to all types of commodities including gold and silver. Betting on the future has expanded its scope to betting on the bet
on the future.
There is a difference between buying shares of a company and betting on whether the company’s share price will go up
or down. The stock certificate says you own so many shares of a company. Your ownership provides capital to the
company to make it successful. You are buying these shares because you think the company will grow and prosper. It’s
rather like Heifer Inc. You are not the farmer who owns the cow directly and can touch and feed it. You buy the paper
(stock certificate) that says you own shares in how much money it provides the owner. You want the owner to be
Now if you wish to bet on whether the cow or the company will do well, you could buy a contract saying the worth of
the stock certificate will go up or down. That is a bet on the stock certificate’s value. You are not betting on the real cow
or company but on a piece of paper’s worth. This is a derivative. It doesn’t have to stop there. Someone else could sell
you insurance to pay for a loss if your guess on the price was wrong. Then the money you would lose will be covered by
an insurance contract on the bet. Someone could also put these bets together with other bets and create a certificate that
says someone owns a share of the pool created by gathering all these bets into a single investment. This is what happens
with mortgages. Your mortgage is sold to an investment that is a pool of many mortgages.
One cow or one company could create multiple derivative instruments. You can see that this will become quite
complicated and difficult to track. The derivative market does not lend itself to transparency and therefore causes buyers
to be in the market just to make money and not to provide a healthy growth prospect in the markets. It also lends itself
to more money held in paper betting on paper. If you could chart all these contracts and connect them to each other, you
may find that one share’s value was bet on multiple times and some people lost money and others had a gain. But none
of them added value to the company by providing growth.
If we wish to take actions that provide clarity and straightforward investing in our human and natural resources, betting
will probably not be the way to accomplish that goal.
This article is for educational purposes only. Derivative investments are not offer by or through Hansen’s Advisory Services or
Cadaret, Grant & Co., Inc