Derivatives & you

A primer on the world’s most misunderstood set of financial instruments

Published

Jan 09, 2024

Author

Paul Fortin

Derivatives have a tendency to sound more complicated than they are. In this article I will explain, in simple terms, what derivatives are, why we need them, and how they benefit both the businesses that use them and even the average consumer.

Why are they called derivatives?

The word “derivative” can be used to describe a book, movie or piece of art whose premise or execution is said to be derived from another pre-existing/original work.

The connection in the financial industry is very similar since traded derivatives, by definition, get their value from another source — either from an instrument such as an index or from assets like stocks, bonds, currencies, or commodities. As the value of the underlying asset moves, the value of the derivative moves. The latter is literally derived from the former.

For illustration purposes, let’s take corn — the first commodity traded in the U.S. using derivatives. To revisit my earlier comparison, the “underlying” asset for corn derivatives is actual corn. Therefore, corn derivative contracts will increase or decrease in value depending on the current and expected future price of corn.

Why do derivatives exist?

Before the advent of corn futures, commercial corn farmers had to grow and harvest their crops while also being forced to line up their own bespoke roster of buyers, brokers and dealers to whom they would sell their annual yield via a series of one-time transactions. And when all the year’s corn was sold, the extensive process started all over again.

This system technically worked, but the time and effort it took to initiate, conduct and complete any given transaction was laborious and expensive for market participants. And since there was notable uncertainty about where corn prices might be by the time the corn was ready to actually go to market, farmers lived with the huge risk that one of their buyers might demand a last-minute change to the terms or back out entirely.

When standardized corn derivatives contracts were introduced on Chicago commodities markets beginning in the 1880s, this costly friction quickly dissipated as trades could now be transacted on a regulated exchange. With individual farmers no longer having to search for buyers of their corn, lengthy negotiations were eliminated. As the process evolved, market participants were guaranteed that the counterparty would adhere to the contractual terms and execute the agreed upon transaction.

And since trading now occurred in a single location, trade information became available to market participants everywhere. The benefit of centralized information was that all parties could observe current prices in addition to the direction prices were heading in order to better plan for the future of their respective businesses.

The initial benefits from the invention of derivatives in the corn market were immense.

How are derivatives currently used?

While agriculture methods and practices have improved to a point that would be unrecognizable to the late 19th century farmer, the basic use case for derivatives in this market is relatively unchanged.

Corn farmers still seek downside protection in case prices fall before their crop goes to market. Meanwhile, a packaged foods manufacturer who needs to purchase corn in the near future still wants protection against corn prices rising — and neither party wants to assume the risk of the counterparty backing out of the deal.

By using modern exchange-traded futures (one form of derivatives) to lock in their respective revenues and costs around a predetermined price on a set future date, corn producers and buyers can eliminate price risk and focus on running their businesses. They can also make investments that will lower future costs and provide a more stable and competitive price for their product. And all of these benefits result in less business uncertainty and more predictable earnings, which leads to a lower borrowing cost — and ultimately an increase in the enterprise value of both businesses.

Because of these time-tested market efficiencies, corn futures are currently the most liquid and active market in grains, with roughly 350,000 contracts traded each day. Since the standard size for each contract is 5,000 bushels and each bushel holds roughly 112 ears of corn, there are around 196 billion ears of corn transacted every day in the futures market which is the reason that corn is called “the other yellow gold” in derivatives markets.

Which other industries use derivatives?

Because corn was one of the first derivatives contracts traded in the U.S., corn futures are a great example but derivatives also serve as key industry stabilizers in areas as diverse as energy, finance, interest rates, currencies, environmental and a wide range of other commodities.

They also represent a key risk management strategy against price volatility for key business inputs for some of the world’s largest companies.

Southwest Airlines is famous for its innovative point-to-point routing system and reliance on a single type of aircraft to minimize costs. However, the company also serves as a poster child in the aviation industry for using derivatives to hedge for jet fuel price volatility. And they’re not the only company whose fun image belies utilization of derivatives. In fact, The Cracker Barrel Old Country Store uses derivatives to hedge exposure to interest rate fluctuations and Disney employs a variety of derivatives to manage its exposure to fluctuations in interest rates, foreign currency exchange rates and commodity prices.

All told, 94% of the world’s largest 500 companies now use some form of derivatives to manage their business and financial risk, according to a 2009 survey performed by the International Swaps and Derivatives Association (ISDA).

Who benefits from derivatives?

To be clear, large corporations and traders are not the only ones who benefit from the use of derivatives.

In a mature and competitive economy, the risk-management benefits and associated cost savings realized by companies through the use of derivatives are, in fact, passed to the consumer in the form of lower and more stable pricing.

This is one of the reasons we’re pioneering the use of derivatives in the auto industry. Undoubtedly, our index-based derivatives will benefit rental car companies, automotive captives, insurance companies, leasing companies and banks. However, the real winner will ultimately be the consumer, for whom derivatives can result in more competitive automotive leases, daily rental fees, subprime auto loans, insurance payments and even accelerate EV adoption and new mobility financing models such as subscription services and used vehicle leasing.