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.