Derivative (Financial)

Background

A derivative is a financial security whose value is dependent upon or derived from an underlying asset or group of assets—a benchmark. The derivative itself is a contract between two or more parties, and the value of this contract is determined by fluctuations in the underlying asset.

Historical Context

The concept of financial derivatives is not new; however, their modern form gained significant traction in the latter half of the 20th century. Historically, derivatives were used primarily for hedging risks related to agricultural production. The Chicago Board of Trade (CBOT) played a significant role in popularizing these financial instruments during the 19th century.

Definitions and Concepts

A derivative can be defined as:

Derivative (Financial): A tradable security whose value is derived from the actual or expected price of an underlying asset. The underlying asset could be a commodity, security, or currency.

Examples of Derivative Instruments:

Futures Contracts: Agreements to buy or sell an asset at a future date for a specified price.
Options: Contracts granting the investor the right, but not the obligation, to buy or sell an asset at a set price, either within a certain timeframe or on a specified date.
Swaps: Contracts in which two parties exchange financial instruments, often used to swap cash flows.

Major Analytical Frameworks

Classical Economics

Classical Economics has limited interaction with complex financial derivatives, focusing more on fundamental market functions and real assets rather than financial engineering.

Neoclassical Economics

In neoclassical economics, derivatives can be regarded as tools for efficient market hypothesis adherence, where they help in price discovery and risk distribution among investors.

Keynesian Economics

Keynesian Economics acknowledges the role of derivatives mainly in speculation and hedging, impacting aggregate demand and supply indirectly, particularly in financial sectors.

Marxian Economics

Marxian theorists often critique derivatives as instruments increasing capital volatility and speculation, contributing to financial instability and exacerbating economic disparities.

Institutional Economics

Institutional economists study how the framework of formal rules, policies, and institutions governs the creation and trading of derivatives, influencing market behavior and outcomes.

Behavioral Economics

Behavioral economists investigate how biases and heuristics impact investor decisions regarding derivatives, including mispricing and speculative bubbles.

Post-Keynesian Economics

Post-Keynesian analysis may focus on the uncertainty inherent in derivative markets and their role in amplifying financial instability, advocating for stronger regulation.

Austrian Economics

Austrian economists emphasize the informational role of prices and might critique interventions in derivative markets, preferring market-driven price mechanisms over regulatory frameworks.

Development Economics

Derivatives in development economics are sometimes scrutinized for their usage in managing risks in emerging markets but also for potential volatility impacts on underdeveloped economies.

Monetarism

Monetarists might analyze derivatives in the context of their influence on monetary conditions, inflation expectations, and central bank policy transmission.

Comparative Analysis

Different economic frameworks present varied views on the significance, benefits, and risks of derivatives in financial markets. While they enable risk management and speculation, they are also criticized for potential leading to market instability and speculative bubbles.

Case Studies

Detailed case studies could include:

The 2008 Financial Crisis: How derivatives like mortgage-backed securities and credit default swaps played crucial roles.
The Uses of Agricultural Futures: Early use of futures trading in agricultural commodities to manage price risk.

Suggested Books for Further Studies

“Options, Futures, and Other Derivatives” by John C. Hull.
“Dynamic Hedging: Managing Vanilla and Exotic Options” by Nassim Nicholas Taleb.
“The New Financial Capitalists: Kohlberg Kravis Roberts and the Creation of Corporate Value” by George P. Baker and George David Smith.

Option: A financial derivative that represents a contract sold by one party (option writer) to another party (option holder).
Swap: A financial agreement in which two parties exchange the cash flows or liabilities from two different financial instruments.
Futures Contract: A standardized legal agreement to buy or sell something at a predetermined price at a specified time in the future.