What is a Derivative?

A considerable variety of financial products describe themselves, or are regarded as, “derivatives”. It is tempting to assume that derivatives are uniquely modern devices, produced by sophisticated financial engineering for the needs of a global market. To be sure, the variety reflects the sophistication of the modern financial markets and the breadth of information available. However, many derivatives are quite pedestrian and far from being the “weapons of mass destruction” excoriated by Warren Buffett. Moreover, the typical form of “derivative” is what was previously familiar – to market practitioners and to lawyers – as a contract for differences.

Such contracts are “derivative” because the thing to which the contract relates – often called its “underlying” – is merely the occasion of the contract, not its subject. In a cross-currency swap, for example, no actual currency deal between the parties is involved. In an interest rate swap, no money is borrowed. In a weather derivative, the “underlying” is obviously not part of the deal. To take a classic example from the related sphere of gambling, betting on a horse race does not involve the acquisition of a horse.

Although it is commonly said that derivatives are so called because their value “derives” from some other financial product,¹ this is not very helpful as a definition because it gives no indication of what the purpose of the contract is. We propose the following definition: in a typical derivative contract, two parties anticipate some uncertain future event by agreeing monetary consequences between themselves, these consequences to be determined by the outcome.

The effect of this structure is to make the contract one of pure risk.² Risk is monetized; there is nothing else that the contract is “about”. While considering how this effect is brought about in modern derivatives, we may bear in mind that risk contracts are not new. They include, for example, insurance, wagers, and actuarial contracts.