Derivatives: Financial innovative instruments for reducing risks

The use of derivatives is traced back several centuries. Aristotle, in his story of Thales the Milesian and his financial device, Thales anticipating a strong olive harvest and as a result, entered into an agreement with olive owners to secure the rights to their harvest. When the harvest came and demand for olive soared, Thales sold the rights to the highest bidders and earned a colossal sum of money.

What is a derivative?

A derivative is simply a financial contract with a value that is based on some underlying asset (e.g. the price of a stock, bond, or commodity). It provides a means of transferring risk and rewards associated with a financial activity to another party.

In a derivative transaction, one party would like to increase their exposure to a specific risk, and the other party would also like to take an opposite position.

While some derivatives involve an agreement to exchange a specified quantity of a commodity others are dependent on an event crystalizing or taking place in the future.

The value of a derivative is often based on the price, volatility, riskiness of the underlying. The price of a derivative change when the price of the underlying also change.

and variations of these such as synthetic collateralized debt obligations and credit default swaps

Categorization of derivatives

Derivatives can be categorized based on the relationship between the underlying asset and the derivative (such as forward, option, swap); the type of underlying asset (be it equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives, or credit derivatives); the market in which they trade and others.

The Commodity Futures Trading Commission (CFTC) is an independent agency of the US government to regulate the U.S. derivatives markets, which includes futures, swaps, and some options.

The Commodity Exchange Act, prohibits fraudulent conduct in the trading of futures, swaps, and other derivatives

Who trades derivatives?

Participants in the derivative market are of 3 types namely: hedgers, arbitrageurs and speculators.

Hedgers: Hedgers are market participants who execute trades to offset risks they may be exposed to. The risk could be an exposure to a commodity, interest rate or exchange rate in the market.

Arbitrageurs: Arbitrageurs take advantage of mis-pricing that exist between a derivative and an asset or commodity.

Speculators: Speculators often profit from the market price fluctuations in the market by taking the opposite side of a trade, hedge or contract.

Where are derivatives traded?

Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Financial products such as swaps, forwards, some options and other hybrid derivatives are almost always traded over-the-counter.

Exchange-traded derivatives (ETD) are those financial derivatives traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts are traded. A derivatives exchange acts as an intermediary to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee.

The Korea Exchange, Eurex and the Chicago Mercantile Group are among the world largest derivative exchanges by number of transactions.

Why trade financial derivatives?

Bank for International Settlements, 15th November 2021 Statistical release. The notional value of outstanding derivatives rose to $610 trillion at end-June 2021

The derivatives market is a world power market. This is largely because there are numerous derivatives in existence, available on virtually every possible type of investment asset, including equities, commodities, bonds, currency and others.

PREMIUMS/ PROFIT: individuals and businesses can profit from trading derivatives. This is mostly done through the use of options (timing of call and put options). Selling put options (writers of put options) enable sellers to generate premiums. Arbitrageurs, speculators and hedgers can also benefit from derivatives.

RISK REDUCTION: businesses use derivatives to reduce exposure to unexpected changes in risk exposures associated with interest rate, exchange rate, price, currency and cashflow.

CERTAINTY: Helps in the making of planning decisions. For instance, it helps to reduce uncertainty for farmers who need to plan their cropping and harvesting seasons to avoid adverse effects

Types of financial derivatives

The most common derivative types are futures contracts, forward contracts, options and swaps. More exotic derivatives can be based on factors such as weather or carbon emissions.

Futures contracts are standardized financial contracts that allow holders to buy or sell an underlying asset or commodity at a certain price in the future, which is agreed upon and locked-in today. The futures contract's value is based on the commodity's cash price.

On the futures exchange, it requires each customer to post an initial margin account in the form of cash, government securities or other collateral when the contract is originated. This margin account is then adjusted, or marked to market, at the end of each trading day according to that day’s price movements. All outstanding contract positions are adjusted to the settlement price.

Forwards are priced similarly to futures; forwards are non-standardized contracts arranged between two counter parties and transacted over-the-counter with more flexible of terms and less oversight. Forward contracts can involve the exchange of foreign currency and other goods, not just commodities.

Options are also common derivative contracts. Options give the buyer the right, but not the obligation, to buy or sell a set amount of the underlying asset at a per-determined price, known as the strike price, before the contract expires.

Swaps are derivative instruments that represent an agreement between two parties to exchange a series of cash flows over a specific period of time.

How to use derivatives to manage risks

Buyers and farmers of commodities are exposed to either a future fall in price or rise in price. A futures contract can be used to reduce such risk exposure in commodity prices.

With a purchase of a commodity futures contract, an agreement is made today to deliver a commodity in the future. Forwards being similar to futures are however traded OTC.

Companies that raise money by issuing bonds to investors will have to either pay a fixed rate or a floating rate of interest. A company that issues a fixed rate bond stands the risk of paying a higher amount of interest above market rates if the rate of interest falls. This risk can be offset by using a derivative known as interest-rate swap. This swap is an agreement between two parties to exchange a fixed rate of interest to a counterparty in return for receiving a floating-rate of interest.

Investors become exposed to credit risk, if they own a company debt. Credit default swaps (CDS) can offer protection against default by the company.

Effects of financial derivatives

The widespread trading of these instruments is both good and bad because although derivatives can mitigate portfolio risk, institutions that are highly leveraged can suffer huge losses if their positions move against them.

In 2002, Warren Buffet, in a letter to Berkshire Hathaway shareholders warned about an existential threat in the OTC market. One of which is the fact that a counter party to a trade will be unable to meet the financial obligations, the second was the lack of margin collateral that can be relied upon to cover potential losses.

During the 2008, financial crisis, this became evident. In the instance of American International Group (AIG), AIG sold Credit Default Swaps (CDS) on mortgage related assets.

During the crisis, demand for housing fell, as a result, the housing market collapsed, their assets became worthless because customers could not meet their financial obligations, the Fed started raising rates, mortgage holders found they could no longer afford the payments. A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default (by the debtor). This necessitated the need to compensate investors. This had financial implications to the bottom line of AIG’s balance sheet which eventually led to their bailout.

Banks and hedge funds had a lot of derivatives that became worthless in value and could not sell. This uncertainty led to a shut-down of the secondary market and an eventual bailout.

THE DODD FRANK ACT was enacted to strengthen the framework for Over-the-counter derivatives (swaps), it requires that parties that enter into swap trades have adequate capital in place to absorb losses, as well as promote fair and equitable trading.

REFERENCE

Wikipedia.org

Thirdway.org