What is a Derivative?

Prabhat Patnaik

AT a class I took for SFI activists on May 29 on political economy, someone asked me the question: what is a derivative? My answer, I could feel, was unclear to the audience. Since other comrades too would be having this question in mind, I thought I should attempt, hopefully, a clearer answer here.

A derivative is a contract through which the contracting parties trade in risk. The idea of a contract through which risk is traded is not a new one; indeed it is familiar to us all. The obvious example of such a contract is the one we enter into with insurance companies, for getting health insurance cover or motor vehicle insurance cover or crop insurance cover. Derivatives are very similar things, though insurance contracts are normally not included among derivatives.

The risk that is traded through these contracts is usually associated with the value of an asset. Since the trade in this case is not in the asset itself but in the risk associated with its value, ie, is derived from its value, the contract is called a “derivative”. A very simple example of a derivative is when a farmer enters into a contract with a trader that he would give the latter a specified amount of a crop at a specified price at a specified future date. The actual price prevailing at that specified date may be more or less than the specified price. If more, then the farmer has made a loss compared to what he could have got; if less, then the farmer has made a gain. But by entering into a contract at the time he does, the farmer opts for certainty rather than the risk of more or less. And exactly the same is true of the trader. The farmer and the trader have traded risk through this “derivative” contract.

Why, it may be asked, should trade of this sort be at all possible? There are several reasons why it is. First, the expectations about the future price of the asset may differ among the contracting parties, in which case both may think that they would gain from the contract and hence enter into the contract. The farmer in the above example may believe that the specified price in the forward contract he has got into, is above what he expects to prevail on that particular future date, and hence consider himself a gainer from the contract. The trader on the other hand may think the price to be lower than he expects to prevail and hence he too considers himself a gainer. Both therefore enter into the contract thinking they are going to gain.

Secondly, even if all contracting parties have the same expectations about the future price of the asset, they may have different attitudes towards risk, some being more risk-averse than others. Some for instance may be more cautious by nature, while others may be less cautious, or may even love gambling, in which case there is scope for them to enter into such a contract.

Thirdly, even if all parties to the contract have the same expectations about the future price of the asset and also the same attitude towards risk, they may have very different capacities for bearing risk. (This is true in the insurance case, since the insurance company, through the sheer scale of its operations, can bear risk to a far greater extent that the individual, which is why both can enter into a contract with which each is satisfied).

Fourthly, even if the contracting parties have the same expectations, the same attitude towards risk, and even the same capacity for bearing risk, they may nonetheless have different attitudes towards the future, some being more concerned with the immediate future while others are more long-sighted, in which case again there is scope for them to enter into a contract.

The fifth case is when there is an element of swindle or coercion associated with the contract, in which case of course one of the parties enters into the contract either unwillingly or unknowingly. (This was the case with the Bengal peasants under colonial rule who took loans from traders to pay their land tax, by entering into dadan contracts that made them agree to sell a certain amount of a specified crop at a certain time at a specified price to the traders).

While the existence of derivatives has been traced back to the times of ancient Greece, and can be seen in pre-independence India as well, the real explosion in these instruments occurred only recently, with the growth of the financial sector. Derivatives in commodity markets, credit markets, foreign exchange markets, and financial markets are now a common phenomenon. Some of the common forms of derivative contracts are: forward contracts (of which the case of the contract between the farmer and the trader discussed above is an example), and futures contracts, which are very much like forward contracts except that they are standardised contracts drawn up by clearing houses rather than by the parties themselves, and can be traded by these clearing houses.

In addition there are options, where the contracting parties have the right but not an obligation to buy (or sell) an asset at a pre-specified price at a pre-specified date; and swaps which are contracts for exchanging assets that result in the substitution of one stream of cash-flows for another stream of cash flows over a certain time-span. A common form of swap agreement that has been much in vogue in recent years is the Credit Default Swap, which can be understood as follows.

Suppose I hold a claim (a loan) on somebody. I can sell this loan to a third party which makes me a series of payments, but in return I pay the buyer the full value of the loan in case there is a default on the loan, and take possession of the loan myself. The buyer in this case in other words is willing to make a series of payments to insure himself or herself against any risk of default on the loan that he or she holds.

Likewise there can be interest rate swaps, where, say, one stream of cash flows on an asset on which there is a variable interest rate is exchanged against another stream of cash flows on an asset on which the interest rate is fixed. Similarly there can be currency swaps where assets may be exchanged in order to hedge against risks of exchange rate fluctuations.

It is clear that an infinite array of possibilities exist with regard to derivative contracts, and these in turn can be marketed. In the process even newer forms of contracts may emerge, and so on. The question that arises is: what is the effect of these derivatives, and trade in derivatives, upon the real economy?

The usual argument that used to be advanced is that derivatives, by introducing a whole range of new instruments, serve to improve financial markets; they serve to transfer risks from those who are unwilling to bear risks to those who are willing, and as a result the overall burden of risk in the economy comes down. Put differently, since economic agents want to be compensated for bearing risk by an amount which is called the risk premium, the reduction of risk in the economy as a whole entails a reduction, other things being equal, in the risk premium demanded in the economy. This is exactly analogous in its economic effect to a reduction in the interest rate, and therefore increases investment and thereby the capital stock, output and growth-rate in the economy. The proliferation of derivatives in short, by improving the quality of financial markets, has, according to this view, the effect of improving the performance of the real economy.

This view however is wrong. It is based on a conception of capitalism where the system reaches full employment in every period and has a long-run rate of growth equal to the sum of the rate of growth of labour force and the rate of growth of labour productivity. In other words, it sees capitalism as a system that is always in equilibrium, with no demand constraints, no slumps, no crises or fluctuations. In such a world some fine tuning in the financial markets can only make for a better equilibrium, and nothing else. This means that derivatives can only improve the performance of the real economy, which is pretty good to start with anyway.

But once we look at the actual capitalist system we get a very different picture. This is a system where under neo-liberal policies, growth occurs only through the formation of bubbles, and the collapse of bubbles brings crises. Now, the introduction of derivatives on a large scale implies, in this scenario, a camouflaging of risk. Nobody quite knows how much risk any enterprise or financial unit is exposed to by virtue of holding the portfolio that it does.

During the boom therefore when the bubble is expanding, there is a tendency on the part of the banks and other financial institutions to underestimate the risk for this additional reason, namely that the actual risk situation of any production or financial unit is shrouded in mystery, and therefore keep expanding credit. This keeps the bubble going, as happened during the housing bubble in the USA when a good deal of what came to be called “sub-prime lending” occurred. By the same token however when the bubble bursts, as it inevitably does like all bubbles, the crash is all the more severe, posing in particular an acute threat to the viability of the entire financial system.

It follows therefore that the introduction of financial instruments like derivatives, which are claimed to improve the performance of the real economy, actually exaggerates the slump and makes the financial system extremely vulnerable. Many factors no doubt went into the 2007-8 crisis which still continues, and in the wake of which the Obama administration had to pledge $13 trillion of State funds to shore up the financial system; but one factor that no doubt contributed to this dire situation was the camouflaging of risk which the introduction of derivatives has made possible.

          

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