What In The World Is A “Derivative”?

Suppose you are a farmer.  Come spring you plant your crop and then wait for nature to take its course.  As you wait, you eye the horizon for clouds, realizing that you are at the mercy of the elements.  Anything could happen that might cost you your crop.

Then someone knocks on your door.  It’s a man in an expensive suit wanting to buy a portion of your crops while the seeds are still germinating in the ground.  But there is one catch to his offer; he’s offering you a price below market.

You understand the benefit in his offer because you know that your crop could fail.  His offer looks and feels much like insurance to you, the price of which is the sharing of profits if the crop produces well.  You both understand this.

At stake in such a transaction, just as in our discussion of debt, is the future, and future production. 

If you do decide to sell, a contract is drawn up and signed.  That contract now becomes part of the “futures” market, and since it derives its value from a portion of your future production, it is called a “derivative“.  This derivative can now be bought and sold by the owner of the contract.  

This derivative’s value will probably vary.  If a dry season threatens your crop its value may go down. If crops elsewhere in the world fail it may go up.  It could very well be bought and sold several times with profits or losses while your crop sits growing in the field.

These kinds of contracts do not apply to crops only however.  They could apply to all sorts of other contracts that derive their value from future production.  Even portions of your own future might be winding their way around these markets.  If you have signed a contract to repay a loan, as with a mortgage, you can almost bet on it.

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1 Comment

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One response to “What In The World Is A “Derivative”?

  1. Just more phony money really.

Shoot... bullets only, no shotguns please.

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