Thales of Miletus may have struck history's first derivative deal, on olives
Aristotle tells how the philosopher Thales profited from a contract on olives, an arrangement some now see as the earliest known derivative, although Aristotle himself called it a monopoly. Today such contracts, whose value rides on something else, form one of the three main families of financial instruments alongside shares and bonds.
Every derivative has four parts: an underlying item, a future action such as buying or selling it, a set price, and a deadline. The thing underneath might be corn or oil, shares or bonds, an index of prices, foreign money, or the going rate of interest. Common forms include forwards, futures, options and swaps. Some lock both parties into the deal; options give the buyer a right but not an obligation. Rice futures have traded on Japan's Dojima Rice Exchange since the eighteenth century.
People use them for two broadly opposite purposes. Hedgers treat them like insurance, taking a position that moves against their existing exposure so a loss on one side is offset. Speculators use them as bets, often for leverage, since a small move in the underlying can swing a derivative's value sharply. They also open doors to markets that are hard to trade directly, such as weather.
Some trade on exchanges like the Chicago Mercantile Exchange; many more are arranged privately, over the counter. The sums quoted are staggering. The Economist reported that in June 2011 the over-the-counter market alone stood at roughly 700 trillion dollars in notional value, though some economists argue that figure hugely overstates real market value and risk. Even scaled down, it dwarfs the United States government's 2012 spending of 3.5 trillion dollars.
Credit default swaps, a form of insurance against borrowers failing to pay, are considered especially risky, and in 2002 Warren Buffett famously warned about this type of contract. In the United States, the Dodd-Frank Act of 2010 brought derivatives under new rules, handing much of the detail to the Commodity Futures Trading Commission. An older American headache, the gambling dens called bucket shops, was outlawed in 1936.
Source: Derivative (finance)
