Q&A

A cheap, but risky, way to make a fast few million

What on earth is a derivative?

A financial instrument used to bet on changes in the prices of assets ranging from wheat or oil to shares and bonds.

Derivatives were invented to protect businesses from unpredictable fluctuations in commodity prices, interest and exchange rates. Companies - or farmers - use them as a kind of insurance policy.

For the farmer fearful of a bad harvest, or a company importing raw materials it must pay for in foreign currency, derivatives are invaluable. Simple derivatives give the right to buy or sell another asset for a particular price at a particular date (a future) or the chance to do so (an option).

How can trading in derivatives lead to such huge losses?

Because users are able to bet on changes in the price of an asset at a fraction of the cost of buying that asset.

For instance, on a futures exchange you could buy the right to acquire 1,000 barrels of crude oil at a certain price in six months by putting up a tenth of the cost of that oil. If the price of oil went up, you would pocket the benefit of buying at today's prices without having stumped up for the oil. If you bet wrong, you would pay the full loss of buying the oil at the old price and selling it at a lower price.

Where did Barings go wrong?

The trader made a huge bet that Japanese share prices would rise before mid-March. They have been falling instead.

Why has the growth in derivatives been so rapid?

Since the world abandoned fixed exchange rates in 1973, financial markets have grown increasingly volatile, driving up the demand for precautionary measures. Growth in derivatives based on financial assets such as bonds, currencies or shares, has exploded since the mid-1980s.

Why have derivatives suddenly become such a worry?

What has scared regulators is the way banks have taken to speculating by using derivatives to make risky bets at low cost. They began to issue warnings about derivatives in 1992. Financial institutions made millions of dollars in 1993 when they bet that interest rates would fall and stock markets would rise. The bet came unstuck when US authorities unexpectedly raised interest rates last year - catching out most punters in the banking community.