Many people hate derivative instruments: futures, options, futures (or forwards), swaps, CDFs, and so on. Yes, because derivatives are often seen as an artificial forcing of the investment world. They are linked to the idea of speculation, high risk and, often, shady activity. In fact, some unfortunate financial episodes (such as the infamous Monte dei Paschi di Siena derivatives and the US subprime crisis) have contributed to fueling these popular beliefs.
Bergamot finance
But the reality is that derivative contracts arise spontaneously from human trading activity. In fact, derivatives are created to satisfy very simple needs and not at all related to high-risk speculation. Now I'll show you with a real example detached from the world of finance.
A few days ago I received a newsletter from a company that sells fruit and vegetables online. Finding ourselves now at the beginning of the bergamot season (for those who don't know it, it's a fantastic Mediterranean citrus fruit, typical of Calabria), in the newsletter they offer me the following:
Basically, they expect me to receive a certain quantity of bergamot for the entire autumn and winter season at a price set today. Since the price is blocked for the whole season, if I accept the offer I will not suffer the effects of market fluctuations (for example, last year the price of bergamot rose a lot during the winter). Well, gentlemen, what have we got here? A term contract. On bergamot. That is a brand new forward on bergamot, a nice derivative… on bergamot.
The origin of forwards and futures
And I will tell you more. If the contract in question were standardized in terms of amounts and deadlines, and managed through a stock exchange (which basically cancels out the counterparty risk, i.e. the risk that I pay but then not receive the agreed bergamot), well, we would have a futures contract.
Forward contracts and futures on stock indices, interest rates, currencies, commodities and any other form of financial asset were born just like that. Naturally, and not to speculate aggressively, or destabilize a market. There is nothing wrong with derivatives per se. They can only be misused. For example, by creating excessively complex products, incomprehensible to most, with the main aim of drowning high commissions within the product – a typical unhealthy use of derivatives.
But it's not the fault of derivatives, but of those who use them for sinister ends.
