Historical Evolution of Derivatives
Financial derivatives are contractual agreements between two parties that agree to engage in the transaction of an underlying asset. The most common use cases for financial derivatives started in the 1930s.
They were commonly used for hedging price fluctuations of commodities such as oil, wheat, and other crops. Since the demand and supply of crops were inconsistent and unpredictable, farmers used financial derivatives to hedge themselves against price uncertainty.
In the instance of wheat, farmers would expect future cash flows from the sale of wheat based on the usual crop yield. And, if crop prices fell dramatically before the wheat was harvested, farmers would end up with fewer revenues than expected. However, despite such unpredictable crop revenues, farmers were able to sell their wheat even before its harvest. They did this by selling long-dated futures contracts, thereby taking advantage of prices by selling futures contracts that would not settle until the wheat had been harvested. In the event that wheat prices dropped significantly by harvest time, farmers were hedged because the buyers of the long-dated futures
contracts were obligated to take delivery of wheat at the purchased futures contract prices. On the other hand, if the price of wheat increased by harvest time, the farmers would make less money as compared to what they would have made had they not hedged themselves, because in such an event they were obligated to deliver the wheat at the futures contract prices.
These derivatives contracts were governed by a centralized clearinghouse that managed all derivatives contracts and regulated the buyers and sellers of these contracts. Both buyers and sellers were required to meet statutory margin requirements before engaging in these contracts. This ensured that both buyers and sellers were able to fulfill their contractual obligations of purchase and delivery. This laid the foundation for several derivative products of today.
Similar to commodity futures contracts being used as insurance against price uncertainties, many financial derivatives today are widely used as insurance in the form of options contracts against anomalous price movements or volatility of underlying assets such as stocks, cryptos, currencies, bond yields, etc. The global derivatives market is estimated to be $500 trillion.