The key to understanding the derivatives market is knowing that these investment products are just what they say they are: derivative.
All products have some underlying asset or key reference data to which they are linked for pricing purposes. It might be a company's share price, or the stock index those shares are traded on.
Equally, it might be a commodity – coffee or copper or a currency. It might also be a bond price or a rate of interest.
This is the side to investment that can seem terribly arcane to beginners: swaps, futures, options. Then you have the initials: CFD, CDS, CDO.
We've written a course here that provides the simplest possible explanations to derivatives trading, but here we'd like to show how flexible this market is.
If you think basing derivative products on coffee or copper is already fairly exotic, then take a look at these five esoteric trades.
1. Weather derivatives
Insurance can only protect against unexpected extremes of weather: hurricanes, tornadoes and floods. But if the rainfall in the US corn belt falls too short of the annual average, a poor crop can result.
Commodity traders who buy up thousands of acres of grain a year, even before they are grown, can suffer severe losses if harvests fail to meet expectations.
One way they can mitigate these losses is to invest in weather futures.
The Chicago Mercantile Exchange (CME) offers futures in tangible assets such as orange concentrate, pork bellies and soya beans. But since 2010 it has offered rainfall futures based on the CME Rainfall Index.
And this is just one of the more recent of a suite of products aimed at helping agribusiness, tourism, energy production – any industry reliant on clement weather – to hedge their potential exposure to bad weather.
2. Bermuda options
An option is an agreement with a broker/vendor to purchase or sell a specified quantity of an asset at a certain point in the future.
In the US, options are more flexible and can be exercised any time between purchase and the date of expiry. But they are more costly than European options, which can only be exercised at the date of expiry.
Bermuda lies in the Atlantic Ocean, somewhere between America and Europe, and Bermuda options are, similarly, somewhere between US and European options. They are an example of what is called a hybrid security.
So, let’s imagine I enter into an option deal to buy 100 shares of Sigma Corps at £10 in 30 days. I'm hoping the price will rise between contract purchase and expiry, so I can buy the shares at £10 on the date of expiry in 30 days, and sell them on the market for a profit.
With a European option, I must wait for the contract expiry to exercise my option. With a US option, I could terminate at any point – watch the stock rise and get out at what I think is the best price.
A Bermuda option is somewhere in between. The broker of the deal will offer me certain specified dates between contract purchase and expiry at which I can exercise my option.
3. Freight derivatives
London's Baltic Exchange offers commodity traders and shipping companies ways to hedge their exposure to the costs of transporting raw materials such as oil and iron ore around the world.
Based on several specific trading routes, the Baltic offers swap agreements called forward freight agreements (FFAs).
Rather like interest rate swaps, one party takes a view that the rate to transport a commodity will be higher, or lower, at a certain point in the future. The counterparty takes the opposing view and the swap is settled in cash at contract expiry.
The Baltic exchange also produces several daily-updated indexes based on certain shipping routes and certain sizes of vessel. Derivative contracts can be based on those indexes too.
And here are some even weirder ones that never made it:
4. Policy analysis markets
This was a futures market proposed by the US defence department to allow trading of futures contracts based on possible political developments in the Middle East.
The theory was that the investment value of a futures contract on a particular political event reflected the probability that the event would actually occur – for example, the outcome of polls or elections.
Some US officials claimed, however, that such offerings would encourage speculation on events such as coups d'état and terrorist events.
Although the project never made it, similar schemes were tried. Eventually the Dodd-Frank Bill banned all futures trading based on events such as assassinations and terrorism.
5. Movie futures
Futures contracts based on box office revenues were proposed for approval to the US Commodity Futures Trading Commission.
There was much hype and the proponents of these securities suggested studios could use such futures contracts to hedge against box office flops.
However, some of Hollywood’s biggest studios opposed the idea on the grounds that rivals could manipulate the market to try and steer public opinion.
Box office futures were included in the Dodd-Frank Bill’s list of banned derivatives, fearing the possibility of insider trading.
To learn more about derivative trading, study our course