[MUSIC] What financial market dwarfs the combined values of all other markets put together? What financial market was implicated for the first time during the crash of 2008? Answers to both questions is the market for derivative contracts, or simply derivatives, which derive their value from changes in the price of an underlying commodity, security, or asset that they represent. Let's start by breaking down what that means. Commodities are goods that are hard to differentiate, like, grain, metals, electricity, oil, beef, coffee, natural gas, and so on. Securities typically refer to financial investments such as, stocks and bonds. Whereas, assets refer to anything and everything that can be owned, which are tangibles such as currency, cars, buildings and machinery or intangibles such as brands, patents and trademarks. Each derivative is based on at least two parties who trade the risk of an uncertain future price by agreeing on a price today. The fundamental elements of a derivative contract can be traced all the way back to ancient Babylon. In Hammurabi's Code, the oldest set of written laws on record specific references are made to arrangements involving the delivery of goods for an agreed price, at a future date, with required contracts that were witnessed in writing. In ancient Greece, Aristotle recounts the story of Thales, the poor philosopher who developed, quote, a financial device of universal application, unquote. Thales negotiated the privilege for an exclusive option, which is a type of derivative, to use the local olive press, by making a deposit that was enough to satisfy the owners. This deposit served as a hedge for the owners in the case of a poor olive yield. Yet, the opposite happened. An excellent olive harvest increased the demand for the press that Thales had predicted, which allowed him to charge a very high price and thus make a killing. Today, modern options, which are a type of derivative, are much more sophisticated, but work on similar principles. Like the Thales example, the holder, or the buyer, of the derivative pays a relatively small premium, or price, which gives them the right, but not the obligation, to buy or sell the underlying commodity, security, or the asset, at a fixed price. The fixed price is also known as the exercise price which applies during the fixed time period. The other party or the seller of the derivative writes the auction contract and receives the premium right away. Which, by the way, is only a fraction of the value of the commodity, security or asset. They, however, take the opposite view of the future price. The holder and the seller in essence are betting against opposing sides of the future value of the derivative. One stands to gain, and the other one will lose. So it is a zero sum game. Derivatives also originated among the merchants of medieval Europe who carried samples of silk, spices, or metals, rather than the entire cargoes as evidence of commodities that were held for future delivery. They traded lettre de faire, or contracts, in trade fairs. Which are the precursor to the modern forward contracts that are customized to meet the needs of the two parties and where payment is made at a specific time in the future at today's predetermined price. Financial historians also point to the Japanese samurai, who issued tickets in the Dojima Rice Market, near Osaka in 1730, to purchase surplus rice at a later date for a pre-determined price. These tickets serve the same function as today's Futures contracts. Forward and futures contracts different in specific ways. Where as modern futures contracts trade in exchanges for standardized amounts, forward contracts are customized. Standardization requires a contract to specify the underlying commodity's quality, quantity, and delivery and ensure that both parties contribute enough cash to execute the transaction. The CME Group, which includes the Chicago Mercantile Exchange and the Chicago Board of Trade is the biggest global futures exchange with billions of contracts traded that are worth over $1 quadrillion in annual turnover. For forward contracts, it's up to the parties involve to characterized the underlined commodities quality, quantity, and delivery. Yet, another type of derivative swaps, are the most reason tradition to the derivative family, introduced in the 1990s as a way for banks to protect themselves against large loans they made to their clients. Swaps, and more specifically, credit default swaps, or CDSs, are mostly designed as insurance products. In other words, if you have loaned money to another party, you're buying the CDS to protect yourself from repayments that you may not be able to make. On the other hand, the writer or seller of the CDS who receives the swap fee must honor the payments triggered by a negative event and be liable to repay the loan. Like all other derivative products swaps, in essence, are transferring risk.
