To start with, a very nice 21st century definition:
A derivative is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments are to be made between the parties.
We have all become a lot more aware of these derivatives in the last few years culminating in the Banking Crisis of 2008.
So what has this to do with sheep farmers in the Norman period of our history who were producing wool. Well during the 12th and 13th centuries in Britain the vast majority of the population were poor. Success was deemed as surviving the winter to see another summer. Most trading, whether vegetables, wheat or any other produce was about the day-to-day need to feed yourself and the family. The same was true with wool merchants, who sold their wool in the Market Square for what anyone would pay for it.
The landowners or the Monasteries had a great need for monies up front, while those newly developing traders looking to sell the wool overseas were looking to acquire as much good quality wool as possible.
So, slowly but surely the trade developed where the producers of the wool started to sell their wool in advance, i.e. they would contract to sell their wool in advance to the middle men who would then export overseas.
It was not long before the producer’s of the wool, which in many cases were the Monasteries, began to sell next year’s wool. This eventually led to wool being sold up to several years in advance. Therefore within a short period of time, a large percentage of the wool was disposed of by advance contracts, this being the practice of many of the monasteries, who would sell their wool from a couple of years or sometimes as much as fifteen and twenty years ahead. Eventually, although small in number to begin with, there were merchants, both in Britain and abroad who were becoming rich in liquid capital.
By selling the wool in advance of production, this use of ‘derivatives’ allowed the risk related to the price of the underlying asset, the wool, to be transferred from one party to another.
For example, the wool producer and the trader could sign a futures contract to exchange a specified amount of cash for a specified amount of wool in the future. Both parties therefore reduced a future risk: for the wool producer, the uncertainty of the price, and for the trader, the availability of the wool.
However, there was still the risk that no wool would be available because of events unspecified by the contract, such as the weather, which was a very big problem in this country or that one party would renege on the contract.
You cannot but help think sometimes that there is nothing new under the sun!
If you would like to understand the history of your own pensions or investments or wish to make a positive difference to your own finances, please feel to call us on 01626 833225 to find out more.