Eli5: It’s said that the derivatives market is worth over $1,000,000,000,000,000. Where did all of this money come from?

Question

Eli5: It’s said that the derivatives market is worth over $1,000,000,000,000,000. Where did all of this money come from?

In: 5

Answer 1

The best way to look at it is with a “simple” example.

Let’s say you own $1 million in stock. You’re worried that the stock might go down, so you want to buy insurance against that.

Now, let’s say someone else is happy to sell you that insurance. They say, “I will buy $1 million in stock from you at the current price for the next two years. If you agree, you pay me an insurance premium of $25,000.”. You decide it’s worth it and you write this contract, known as a put contract, with this person.

You’ve just added $1 million in value to the derivative market, or the nominal amount of stock covered by insurance contracts.

But wait, there’s more — person B gets tired of holding your contract and decides they want to sell it, but you don’t want to sell. So they find a third person, and they agree to write a contract to person B. The contract is quite similar to yours and Person’s B’s, where they get the right to sell at the current market price $1 million of stock.

In a practical sense, person C is now your insurer.

In reality, another $1 million has been added to the derivative market. It’s the same stock, but it’s two separate contracts. These contracts in fact balance liability for one party and shift it to another, but it still seems like a large number of derivatives are written when you look at the nominal face value of all insurance contracts.

In the strictest sense, this quadrillion figure is ultimately meaningless as a result. You could take on $1 billion liability and instantly offset it with the exact opposite contract and be in no riskier a situation while still adding to that figure.

However, like any insurance, and any financial products, you CAN get yourself in a lot of trouble speculating or poorly offsetting your risk with them, so it’s vastly more important to understand your risk profile than any nominal value of the worldwide derivative market to make sense of these things.