What are financial derivatives?

Written by admin on October 31st, 2011

Stock markets have always been volatile, but in the current financial environment, volatility in currencies, interest rates, bonds and stocks is completely new. New variables have been added to the assessment of risk that organizations undertake, thus making essential for companies to find new methods of protecting their assets against sharp fluctuations. This simple need gave birth to a highly complex activity, which is the trading of financial derivatives.

A derivative is a financial instrument that derives its value from the values of other underlying variables, which, in most cases, are the prices of the traded asset. Derivatives are traded since 1848 on the Chicago Board of trade (CBOT, www.cbot.com) to bring farmers and merchants together and standardize the quality and quantity of the goods exchanged. This is how the first futures contract was created, which led, in 1919, to the establishment of a rival futures exchange, the Chicago Mercantile Exchange (CME, www.cme.com). Today, derivatives are traded both in over-the-counter markets and exchange traded markets.

Most financial assets are traded in the spot market where ownership of the asset and the amount to acquire ownership are exchanged between buyers and sellers. However, in some cases, entering into a transaction immediately and exchanging the asset and the money at a future date, seems more profitable. Derivative securities, such as forwards, futures and options, have been introduced to shift the risk to market participants, who can bear it, and usually at a lower cost than investing in the cash market.

(a)    Forward Contract

A forward contract is an agreement between two parties to buy or sell an asset at a certain future time for a specified price. Forward contracts are traded on over-the –counter (OTC) markets, typically between financial institutions or between a financial institution and one of its clients.

The mechanism of a forward contract requires one party to buy the underlying asset assuming a long position at a certain future time for a specified price and the other party to sell the underlying asset assuming a short position at a certain future time for a specified price. However, as forward contracts are not standardized, they are not liquid. The buyer or the seller may withdraw from the forward agreement at any time and look for another party to make a forward agreement with if she thinks it would be more profitable. Also, forward contracts are susceptible to default or credit and they may not be executed as planned if the buyer cannot raise the cash needed to purchase the asset or the seller commits fraud and does not deliver the asset.

(b)   Futures Contract

A futures contract is an agreement between two parties to exchange (buy or sell) an asset at a certain future time for a specified price. Unlike, forward contracts, future contracts are traded on the exchange markets. This requires the exchange to set certain standardized features for the contract.

The mechanism of a futures contract obliges the owner to purchase the underlying asset according to the standardized terms and conditions set from the exchange concerning quality and quantity of the underlying asset and expiration dates. This allows futures contracts to have less liquidity risk than forward contracts and be traded like common stocks on secondary markets. In addition, futures contracts have less credit or default risk than forward contracts because both parties are requires to deposit funds in a margin account, which is typically the 3 to 6 percent of the value of the contract. These funds are added or subtracted from the margin account on a daily basis reflecting the daily price changes in the futures contract. Therefore, futures contracts are marked to market, meaning they are cash-settled daily.

(c)    Options

An option gives an investor the right to buy or sell an underlying asset at a specified price on or before a specified date. The right to buy the underlying asset assuming a long position by a certain date for a certain price is a call option. The right to sell the underlying asset assuming a short position by a certain date for a certain price is a put option. Options are traded both on exchanges and in the over-the-counter markets. The price in the contract is known as the exercise or strike price, while the date in the contract is the expiration date or maturity.

The mechanism of an option contract does not oblige the holder to exercise the right. This is what distinguishes options from forwards and futures, where the holder is obliged to buy or sell the underlying asset. Buying an option carries a limited risk of loss, which is the cost of the premium price (the cost) of the option if it expires worthless and an unlimited opportunity for gains as the strike price and the price of the underlying asset diverge as the maturity date approaches. On the other hand, selling an option offers a limited opportunity for gaining the option premium if the option expires worthless, and the risk of unlimited losses, which depends on how much the strike price and the price of the underlying asset diverge.

Forwards, futures and options are used in a variety of ways from individual investors, but also from corporations. The main reason why derivatives markets are so attractive is because they attract different types of traders and have high liquidity. This means that when an investor wants to take one position of a contract, there is usually no problem in finding another investor willing to take the opposite position.

On the other hand, being highly versatile, derivatives provide unlimited leverage, which actually demands a liquidity that far exceeds the market’s potential. There are cases, that risk managers miscalculate volatility assumptions, typically resulting in large losses for the firm. Also, traders who have the authorization to hedge risks or follow arbitrage strategies may become consciously or unconsciously, speculators.

In conclusion, using derivatives in a well-diversified portfolio is a good way to leverage the risk associated with financial and commodity markets. However, the use of derivatives should be carefully structured.

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