Halloween season or not, people always seem to get the heebie-jeebies whenever they hear the word "derivatives."

"Those things are so complicated – I just don't get it," is one common refrain.

Or: "CDS, CDO, CLO, TRS – it's all Greek to me.”

It doesn't help that derivatives are blamed for the financial crisis and always seem to be just outside the door, like the big bad wolf trying to blow the house down.

But derivatives are often not as complicated or esoteric as the proverbial "they" might lead you to believe….

A derivative, at its simplest level, involves periodic exchanges of payments between two parties, which are typically netted into a single payment by the party owing the greater amount to the other party.

The payments are based on some other thing – whether that be:

Of course some derivatives, like certain equity derivatives, can be complicated where payments between the parties are determined by a complex formula. But most derivatives encountered by finance attorneys are actually quite simple.

For example, in a typical "plain vanilla" interest rate swap, one party (Party A) believes interest rates will rise (or needs to protect itself against a rise or fluctuation in rates), and prefers to lock in the current rate. The other party (Party B) wishes to take the opposite position. In a sense, each side is making a bet (albeit one with a business purpose). So the parties enter into an interest rate swap under which, on each periodic payment date (usually monthly or quarterly):

As mentioned, the parties' payment obligations under the swap are typically netted on each payment date so that only one party – the party that is out of the money on that payment date (the party that owes the greater amount) – must make the payment to the other party on a given payment date.

In this example, Party A is always obligated to pay a fixed amount to Party B under the agreement on each payment date. If the agreed rate is 3.5 basis points and the contract's notional amount is $1 million, Party A is obligated to Party B on each payment date in the amount of $35,000. But it is Party B's obligation to Party A on that payment date that determines who pays who and in what amount…

If market rates have risen above the agreed rate as of the payment date (or another agreed measurement date during the period), then Party B is out of the money on that payment date and must make a payment to Party A of the difference in the current market rate and the agreed rate multiplied by the transaction's notional amount.

If market rates have declined below the agreed rate as of the payment date (or another agreed measurement date during the period), then Party A is out of the money on that payment date and must make a payment to Party B of the difference in the current market rate and the agreed rate multiplied by the transaction's notional amount.

But Party A is never obligated on any payment date to pay more than the agreed rate multiplied by the transaction's notional amount (3.5% x $1 million = $35,000). So it is able to lock in its maximum monthly payment amount.

(Note that one party typically pays a fee to the other party for entering into the swap. The fee is usually paid monthly and is accounted for and incorporated into the parties' monthly net payment.)

A typical credit default swap is even simpler. Under a typical CDS, if a third party (the reference entity) that is named in the CDS contract fails to make a payment on one of its outstanding debt obligations, the credit protection seller under the CDS contract is obligated to make payments to the credit protection buyer. (In a slight wrinkle, there may be a basket of reference entities, as in a CDS index transaction; if any one defaults then payment is triggered.)

If triggered, the payments, are made periodically (usually monthly) to simulate the payments a holder of the debt obligation would receive. The protection buyer pays a periodic fee to the protection seller for this "insurance." Again, payments are netted so that only one party makes a payment on each payment date.

So now that we see these instruments are not necessarily so esoteric and complex, why are derivatives important to finance lawyers?

In addition to documentation and regulatory matters that arise with respect to derivatives, derivatives are important to finance lawyers because their clients use derivatives in the following ways:

Lenders use derivatives to hedge interest rate risks, as well as risks that a borrower may default under a loan. Commercial businesses use derivatives to hedge against exchange-rate risk and risks in the value of commodities that are essential to their businesses, such as oil, agricultural products and precious metals.

Lawyers need to understand how these instruments work so that they can assist their clients with the documentation and attendant legal issues and risks associated with derivatives, and so they can counsel their client with a full understanding of its transactional position and financial picture.

So next time someone expresses fear at the mere thought of a three-lettered acronym, you can comfort them with tales of a plain vanilla interest rate swap. You can also let them know that, despite the confounding acronyms, a CLO is a collateralized loan obligation and a CDO is a collateralized debt obligation. These transactions are not in fact derivatives, but rather types of securitization transactions. Now these can be complicated! (See Diagram: Basic Structure of a US Securitization.) We’ll save those for another time.

For further details and more examples of the types of derivatives transactions discussed above, see:

Practice Note, Derivatives: Commercial Uses.

Practice Note, Derivatives: Overview (US).

For more on the basics of credit default swaps and other types of credit derivatives, see Practice Note, Credit Derivatives: Overview (US).

For details on the basics of total return swaps and other types of equity derivatives, see Practice Note, Equity Derivatives: Overview (US).

For information on the regulation of derivatives under the Dodd-Frank Act, see:

Practice Note, Summary of the Dodd-Frank Act: Swaps and Derivatives.

Practice Note, Road Map to Dodd-Frank Swaps and Derivatives Regulation.

Swaps and Derivatives Compliance Calendar.

Dodd-Frank Swaps and Derivatives Compliance Toolkit.

For details on documentation of over-the-counter (OTC) derivatives, see:

Practice Note, ISDA Documents: Overview (US).

Practice Note, Understanding the ISDA Master Agreement and Schedule.

ISDA Master Agreement Toolkit.