"We view them as time bombs both for the parties that deal in them and the economic system .. In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

- Warren Buffett, the Chairman of Berkshire Hathaway and his critique of the derivatives market. (March 2003)

What are derivatives? You may have heard the word in your high school mathematics class, someone may have suggested you use derivatives as part of your investment strategy, or you may already work with derivatives already.. But what many do not consider, is what derivatives really are on a fundamental level.

You can come up with a hundreds of formulae for derivatives, use them within numerous applications, but in its pure form, derivatives are merely pieces of paper.. Or in more modern day view, electronic contracts which give you a right or an obligation, or a combination of the two to receive or give something in the future. This can be a stock of a company, a foreign currency, wheat, oil, or to take it to its extreme, an agreement with your neighbour for 2 bags of sugar next week.

A derivative is essentially a contract, which has its value derived as a function of some underlying variables. For a stock, the underlying variable is the stock price, for wheat, the underlying is the price of wheat at a certain time, and for the 2 bags of sugar, it could be the difference between the two sugar prices. The aim of a derivatives practitioner is to understand the dynamics behind the underlying variable and the factors which might influence the value of it in the future.

We can highlight the three key uses of derivatives:

1. Hedging
> Hedging using derivatives is commonly used by parties who seek to offset their existing risks by entering into a derivatives transaction. The existing risks could be an investment portfolio, price changes in oil for a petroleum mining company or perhaps investments in a foreign country.

2. Speculating
> Speculation is more commonly used by hedge funds or traders who aim to generate profits with only a marginal investment, essentially placing a bet on the movement of an asset. Although speculation can produce a high return on investment, the downside risks are equally as prominent as demonstrated by the collapse of Long Term Capital Management in September of 1998. Because of the high degree of leverage one can take in speculative contracts, an adverse change in prices could result in rapidly increasing debt and a portfolio worth millions could fall to almost zero with the space of a few hours.

3. Arbitrage
> Opportunities to arbitrage take place throughout the world markets, and derivatives are sometimes used to exploit these. Practitioners working within risk finance or quantitative finance often develop models to price various assets being traded across the markets, and upon finding price discrepancies, one can make use of a specific combination of derivatives in order make a riskless profit.

"These increasingly complex financial instruments have especially contributed, particularly over the past couple of stressful years, to the development of a far more flexible, efficient and resilient financial system than existed just a quarter-century ago,"

- Alan Greenspan, Chairman of the Federal Reserve and his summary of the derivatives market (2002)

The numerous types of derivatives are found throughout this website.

Are derivatives dangerous? That's almost like asking if water is dangerous. Derivatives can be dangerous if used incorrectly - as several large companies and individuals have found out in recent history. This in turn, has led to the advancement of risk management; a profession which deals specifically with managing the risks involved with taking positions in these tools. We therefore disagree with what Mr. Warren Buffett says of derivatives (see top line) as these tools are essential to the efficiency of the markets.

It is a commonly said fact that derivatives contribute to the 'completeness' of the global markets, and without them, loopholes within the financial industry would exist. At this point, it may be worthy to note that even through numerous financial disasters ala Amaranth, Barings, LTCM, Enron and others related to the mismanagement of derivatives, it is key to consider that it has not been the use of derivatives as a tool which has led to the downfall of these companies - but rather, the misuse and compromise of such instruments.

Looking back in time we have seen the evolution of derivatives even way before the invention of the car. Over 2000 years ago, contracts for delivery in the future was commonly used with Greek olive farmers, in the 1600s, Tulip derivatives were used by the Dutch and it was more or less only as Louis Bachelier in 1900 formally introduced futures pricing when people began to take derivatives at more than just face value. With the emergence of OTC derivatives soon after, there were still no sound ways of determining the value of these contracts until Myron Scholes & Fischer Black in 1973 came forth with their classic formulation now just refered to as the Black-Scholes European option pricing model, followed shortly with an extension by Robert Merton pertaining to the inclusion of dividends. At this time, the Chicago Board of Exchange was created.

But these standard 'vanilla' contracts were not enough to satisfy the crave of investors. Equity derivatives and commodity contracts spread to interest rate options in the 1980s and beyond to a rapid expansion in exotic options throughout the 80s and 90s. Looking back at exotic options; we have seen the trading of barrier options as early as the 1960s and because of the widespread use of so-called exotic derivatives, these contracts are no longer 'exotic', with trading volumes exceeding that of vanilla type contracts. And with the expansion of this industry, we will be looking at an even greater volume of packaged hybrid products requiring even more risk assessment to prevent further financial disasters from happening.

This website is focused on the analytical side of derivative products, and although we do not make detailed assessments into the management of risk related to derivative products, we hope that the information provided throughout the website