Derivatives and social inequalities

What is a Derivative?

The term Derivative is used everywhere. Boring calculus books make you derive derivatives. English teachers tell you that a body of work is “merely Derivative”. If the word couldn't get any more boring, you hear the term in the financial context. Most financial articles can't go a paragraph or two without name dropping a type of Derivative. It might be helpful then to know what a derivative is. Below is a definition of derviatives taken from the “Dictionary of Financial Engineering ” by John F. Marshall . Don't worry if you don't understand the definition on the first reading. I will break it down as best as I can.

“A generic term to describe a wide variety of financial instruments ranging from standardized, exchange-listed products to custom-made, over-the-counter instruments whose values depend on, or are derived from, the price or value of one or more underlying assets, including indexes, exchange rates, interest rates, or commodity prices. “

Wow. That had a lot of words. They seemed to logically follow one another in a sentence, but at this point some of you are taking my word for it that that meant something. Let's take the first part. What is an “exchange-listed product”? This just means that there's some trading floor (or some place online), similar to the New York Stock Exchange, where people will buy and sell financial products that do the same thing. In other words, the products are fungible. Just like one dollar bill does exactly the same thing as another dollar bill, one of these financial products does (or is supposed to do) the same thing.

From this, it's easy to figure out what a “custom-made, over-the-counter instrument” is. It's simply the opposite! Rather then being “listed” on some exchange somewhere and buying it on an exchange, people buy the products on their own. More specifically, there's a person named a “dealer” (also called a “market maker”) who both buys and sells the same product and makes money on the price difference between the price he/she pays for products and the price he/she is paid when selling them (or at least that's the ideal, more on this in later posts). You can think of a market maker as similar to your local corner or grocery store. They buy products from suppliers, sell those same products to you and make money on the difference.

Now how about that second part? “Instruments whose values depend on, or are derived from, the price or value of one or more underlying assets, including indexes, exchange rates, interest rates, or commodity prices”. This is much simpler then it sounds. All that's being said is a derivative doesn't have some inherent value tied to it, it's worth is based on the value of something else. I'll give a simple example. Let's say that I go to my local farmer and tell him “hey, if you sign right here, I'll pay you 2 dollars every week for a year for the right to buy a bushel of apples for 10 dollars at any point during that year”.

That's called an “option” because I'm paying for the option of buying apples at a certain price. When the price of apples goes down (up), the value of this option goes down (up) because the privilege to buy a bushel of apples at 10 bucks is less (more) appealing the lower (higher) the price. If I can go out and buy a a bushel for 5 dollars that option won't be worth very much to me but if the spot (immediate) price is 30 dollars the option becomes more valuable. This principal of basing the value of an asset on another asset can and has been extended to nearly every conceivable thing from those listed above to the weather and movie earnings. In the same way your bet on Jeremy Lin is based on Jeremy Lin's performance, you can design a custom contract to be valued based on the performance of nearly any measurable thing on the planet just as long as you can find someone to take the other side of the bet.

What does this have to do with social inequalities?

Everything. Derivatives exemplify everything about the fact of social inequality and its media discussion. While electoral politicians go back and forth endlessly on tax cuts (the supposed marker of “evil” inequality loving republicans and “equalizing” democrats is their position on marginal tax rates for high income earners), products such as derivatives escaped their traditional place in agricultural markets to infest nearly every part of finance. Large sectors of the American economy and social structure have been able to use products with complex (but longer term) risks and uncertainties to squeeze out millions (if not billions) in the short term while blowing up their companies in the long term and then putting them on the publc's doorstep.

As James Galbraith and his co-author Jing Chen said in a relatively recent paper:“When a part of an organism escapes regulation and turns into a free market, that part of the organism will grow rapidly. This is called cancer. In the end, the unregulated growth, if it is not stopped, will drain all the resources of the organism and destroy the organism. In human society, if an economic sector gains control of large amount of resources and escapes regulation, it will grow rapidly and generate huge profit for the insiders. But the process will drain resources from the whole society. This is what we have witnessed in the current financial crisis”.

In this context, who really cares whether the top marginal tax rate is 35 percent or 39.6 percent? No one tries to deal with cancer simply by putting in place marginal measures to prevent it's growth. People first try everything they can to kill cancer or have it removed. Derivatives are at the center of this process of cancerous growth but because they are complex and (almost deliberately) confusing, they have stayed out of the public eye . More or less the only people who comment on their nuances in legislative fights and public arenas are those who benefit the most from keeping them opaque, unregulated and off-balance sheet. Next time you're at a casino, try a game that you don't know the rules to. That's the game the public is forced into in many areas, but especially in finance.


Chen, Jing and Galbraith, James K., A Biophysical Approach to Production Theory (December 8, 2008). Available at SSRN: http://ssrn.com/abstract=1313366
Marshall, John F. Dictionary of Financial Engineering. New York: Wiley, 2000. Print.