A derivative is a financial product the price and return of which derives from prices of underlying assets

If you had the option of signing a contract today to buy a scoop of ice cream from me in one month, and to pay 90% of the price of a loaf of bread on that day for it, would you take it? If so, you and I have just entered into the derivatives business. That is, if I understood correctly what Julien Glachon, financial risk management officer in the derivatives division of the European Investment Bank, was telling us on this week’s show of ‘A Dictionary of Finance’.

He talks about plain vanilla derivatives, which, unfortunately, are not edible: the put option and the call option are basic forms of derivatives. (The prior example with the scoop of ice cream, I’m pretty sure, would qualify as a call option – a call for ice cream, to be specific).

But derivatives are not just about satisfying your frozen yoghurt cravings. They can include bets on the market (which way will the price of bread go?) or hedging against bets you have already taken. For example, if you have a lot of bread in production, and you’re worried the price of milk might go down, you may be interested in the said derivative, because in case it does, you would at least get a lot of fairly cheap ice cream.

Glachon also describes how bankers use mathematical formulas that calculate the price for a derivative and then use software to monitor the underlying conditions (e.g. prices of the assets that the derivative is linked to) to constantly calculate a price for the derivative.

We also learn about a replication portfolio, which helps make sure your trading partner can sell you that scoop in various market conditions. (The bank might thus take up a contract in the next weeks, while the price is still high, to sell someone a loaf of bread at the ice cream scoop delivery date). Are you getting a brain-freeze yet? No?

Well, then consider the interest-rate swap as described by Julien. A company takes out a loan with a bank which is only willing to offer floating interest rates. The company, not happy with that, then goes to another bank and creates a derivative on the initial loan. The company pays this other bank a fixed interest rate, and receives whatever the current floating rate is, which it then passes on to the original lender.

Ok, now you deserve an ice cream!

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