A simple, textbook definition of financial derivatives will typically resemble the following:
A derivative is a financial contract, asset or instrument that derives its value from another underlying security.
Typically, derivatives are treated as distinct instruments within financial institutions. Historically, banks have tended to have ‘derivatives desks’ and specialist ‘derivatives traders’.
However, in The Metaphysics of Markets, I question whether this straightforward definition is adequate and likewise whether the segregation of ‘derivatives’ as an asset or security class is appropriate. This is because the fundamental nature of derivatives contracts can be hard to pin down. After all, what about well known cases of futures markets ‘driving’ spot markets? Does this make the relevant underlying contract derivative?
My suspicion is that derivatives instruments are generally misclassified. A better approach is to realise that derivativeness is a property or attribute rather than a class in its own right. And whilst certain commonly-perceived to be derivative instruments such as options contracts exhibit a great deal of derivativeness, this is not the same is simply classing them as derivative instruments simpliciter.
Why does this apparently subtle difference in interpretation matter? It matters because derivatives as currently conceived are thought to be separable. It is thought that derivatives can neatly be isolated in terms of their risk and character and even in terms of their users. But this could well be a false impression. If derivativeness is thought of as a property that many assets can exhibit, this is more than just a change to our current perception. It has profound implications with respect to regulation and risk management for instance.
Derivatives instruments (although this term is formally question-begging in any enquiry into the nature of derivatives) are generally thought to be well defined and understood. However, to my mind, the elementary definition of derivatives that is commonly accepted, is insufficient. This means comprehension of derivatives and their impact is based on a false proposition from the outset. And this is never an optimal starting point.
Read more and buy the book…
The Metaphysics of Markets