History of Derivatives

Derivatives may have found their way into the media in very recent times. However, they have been used by mankind for a very long time. Since the inception of time, humans have not liked the idea of uncertainty. More so, they did not like the idea of economic uncertainty. Hence, the need to offset this uncertainty gave rise to the evolution of contracts. Earlier contracts were verbal agreements and were not as sophisticated as the ones today. However, they were contracts nonetheless. In this article, we will trace the evolution of derivatives throughout the ages.

Ancient Examples

Derivatives are said to have existed even in cultures as ancient as Mesopotamia. It was said that the king had passed a decree that if there was insufficient rain and therefore insufficient crop, the lenders would have to forego their debts to the farmers. They would simply have to write it off. Thus, the farmers had just been given a put option by the king. If certain events unfolded in a certain way they had the right to simply walk out of their liabilities!

There have been many such examples that have been quoted during the time. Another famous example pertains to Greek civilization when one of Aristotle’s followers who was adept at studying meteorology predicted that there would be a bumper crop of olives that year. He was so sure that he went ahead and purchased the produce of all the Olive farms in and around Athens before the crop had been harvested. In the end it did turn out to be a bumper crop and Aristotle’s disciple made a huge profit from his way ahead of time forwards contract.

19th Century: Chicago Board Of Trade

During the nineteenth century, America was at its pinnacle of economic progress. America was the center of innovation. One such innovation came in the field of exchange traded derivatives when farmers realized that finding buyers for the commodities had become a problem. They created a joint market called the “Chicago Board of Trade”. A few years later, this market evolved into the first ever derivatives market. Instead of buyers and sellers negotiating their own customized contracts, there were now standard contracts listed on the exchange which could be bought and sold by anyone. This idea proved to be a big hit. Soon Chicago Board of Trade had to create a spinoff called Chicago Mercantile Exchange to handle the growing business.

Recently Chicago Board of Trade and Chicago Mercantile Exchange have been merged to form the CME group. It is still one of the foremost derivatives markets in the world. The massive success witnessed by the members of the Chicago Board of Trade led to the creation of many such exchanges across the globe. However, during the era of Chicago Board of Trade, derivatives trading was limited to commodities only. Other financial instruments were largely outside the realm of such trading.

Modern Day

Innovations in the modern financial market have largely been based on the idea of derivatives. What started as a simple idea in ancient times was later developed into standard contracts during the Chicago Board of Trade era has now become a maze of complex financial instruments and contracts. The asset classes on which the derivative instruments were based have undergone a rapid expansion. Nowadays, there is a derivative for pretty much everything.

We have derivatives for stocks, indices, commodities, real estate etc. We even have derivatives that are based on other derivatives creating a Meta structure of sorts. The reason behind this rapid expansion is that derivatives meet the needs of a large number of individuals and businesses worldwide.

After the collapse of 2008, derivatives had to take the fall for the entire chain of events. They were vilified by the media in general. That has come as somewhat of a setback. Barring that the rise of derivatives in the recent years has been nothing short of extraordinary and this is expected to continue in the future.