Simple Derivatives Explained
A derivative comes when 3 conditions are met. There is someone who wants to sell a tangible asset, like paper or oil, even a stick of gum, at a future date. Often, they have no idea what the future price of what they have will sell for, so they seek an investor who will buy from them that commodity (gum, oil, or paper, etc) at a future date at a pre-determined, agreed-upon price. Let’s do a case example:
You have 1 barrel of oil. Right now, as of January 1st, 2017, the price for 1 barrel of oil is $53.90 per barrel. You personally are not sure what the price of oil will be in 1 year from today, but you know you have to (or want to) sell it 1 year from today. You are worried that the price of it will go down.
That’s where the investor comes in and saves the day. The investor approaches you and agrees to buy the barrel of oil from you at $75, no matter what the market conditions are. He is betting that the price of oil will go up dramatically, perhaps to $150 / barrel again, so you both agree to that price 1 year from today.
Now, even if oil goes down to $25 per barrel in market price, you will still sell it for $75. Conversely, if it goes up to $200 per barrel, it will also only be bought from you at $75 per barrel. The purpose of futures and derivatives is to offer a cushion. Unfortunately, however, most of the world is experiencing a derivatives bubble.
The entire world’s money supply is 1.2 quadrillion dollars if you include derivatives, which are the prices of things that haven’t really happened yet – they are just expected to happen at some point. All the actual money in the world, according to Market Watch, is only about $81 Trillion, of which America has most of. What this means is that there is an expectation of more money that actually isn’t there, and could lead to massive problems with inflation or deflation if and when the derivatives bubbles bursts. However, that doesn’t seem likely to happen anytime in the near future.