An Overview of Derivatives
hapter 8 provides a much more detailed discussion of options. We provide an
overview here of derivatives and their use in risk management. As noted in the
chapter, there are four major classes of derivatives: forward contracts, futures,
options, and swaps. Following is a brief explanation of each.
are among the oldest derivatives. Consider a farmer who plans to
harvest wheat in the fall. If wheat prices are high in the fall, then the farmer will
make a lot of money. But if wheat prices are low in the fall, then the farmer might
lose so much money that the farm must be sold. To eliminate this risk, he might take
in a wheat forward contract, or
. This contract
will specify a price, perhaps $3 a bushel, at which the farmer is obligated to sell and
deliver wheat on a certain date in the fall (called the
), no matter what
the current market price of wheat actually is in the fall; this is called the
. Thus, the farmer is using the forward contract to hedge away risk by locking
in the price at which the harvest will be sold.
A baker who plans to purchase wheat in the fall might also like to reduce risk. To
do this, she would take a
in the contract, or
specifies that the baker is obligated to purchase wheat for $3 a bushel on that delivery
date in the fall, even if the current market price is lower or higher. Again, the baker
is using the forward contract to hedge risk.
This example illustrates a couple of points. First, there are two parties to the con-
tract. One takes a short position and one takes a long position. A person taking a
short position is said to be selling the contract because it obligates the person to sell
(in our example, wheat in the fall). A person taking a long position is said to be buy-
ing the contract, because it obligates the person to buy (wheat in the fall).
There is an active market for forward contracts for currencies, where businesses are
on one side of the contract and large banks are on the other. For example, if a wine im-
porter plans on purchasing French wine in the fall using euros, then the importer could
either use dollars now to buy euros or could wait until fall to buy euros. With a forward
contract, the importer could lock in today the purchase price for euros in the fall.
If all forward contracts had to be made face-to-face, the market would be quite small,