Exchange-traded derivatives are standardized and more heavily regulated than those that are traded over the counter. Derivatives were originally used to ensure balanced exchange rates for internationally traded goods. International traders needed a system to account for the differing values of national currencies. Assume a European investor has investment accounts that are all denominated in euros EUR. Let's say they purchase shares of a U. This means they are now exposed to exchange rate risk while holding that stock.
Exchange rate risk is the threat that the value of the euro will increase in relation to the USD. If this happens, any profits the investor realizes upon selling the stock become less valuable when they are converted into euros. A speculator who expects the euro to appreciate compared to the dollar could profit by using a derivative that rises in value with the euro.
When using derivatives to speculate on the price movement of an underlying asset, the investor does not need to have a holding or portfolio presence in the underlying asset. Many derivative instruments are leveraged, which means a small amount of capital is required to have an interest in a large amount of value in the underlying asset.
Derivatives are now based on a wide variety of transactions and have many more uses. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a region.
There are many different types of derivatives that can be used for risk management , speculation , and leveraging a position. The derivatives market is one that continues to grow, offering products to fit nearly any need or risk tolerance. The most common types of derivatives are futures, forwards, swaps, and options. A futures contract , or simply futures, is an agreement between two parties for the purchase and delivery of an asset at an agreed-upon price at a future date. Futures are standardized contracts that trade on an exchange.
Traders use a futures contract to hedge their risk or speculate on the price of an underlying asset. The parties involved are obligated to fulfill a commitment to buy or sell the underlying asset. For example, say that on Nov. The company does this because it needs oil in December and is concerned that the price will rise before the company needs to buy.
Company A can accept delivery of the oil from the seller of the futures contract, but if it no longer needs the oil, it can also sell the contract before expiration and keep the profits. In this example, both the futures buyer and seller hedge their risk. Company A needed oil in the future and wanted to offset the risk that the price may rise in December with a long position in an oil futures contract.
The seller could be an oil company concerned about falling oil prices and wanted to eliminate that risk by selling or shorting a futures contract that fixed the price it would get in December. It is also possible that one or both of the parties are speculators with the opposite opinion about the direction of December oil.
In that case, one might benefit from the contract, and one might not. Not all futures contracts are settled at expiration by delivering the underlying asset. If both parties in a futures contract are speculating investors or traders , it is unlikely that either of them would want to make arrangements for the delivery of several barrels of crude oil. Speculators can end their obligation to purchase or deliver the underlying commodity by closing unwinding their contract before expiration with an offsetting contract.
Many derivatives are in fact cash-settled, which means that the gain or loss in the trade is simply an accounting cash flow to the trader's brokerage account. Futures contracts that are cash-settled include many interest rate futures, stock index futures , and more unusual instruments like volatility futures or weather futures. Forward contracts or forwards are similar to futures, but they do not trade on an exchange. These contracts only trade over-the-counter.
When a forward contract is created, the buyer and seller may customize the terms, size, and settlement process. As OTC products, forward contracts carry a greater degree of counterparty risk for both parties. Counterparty risks are a type of credit risk in that the parties may not be able to live up to the obligations outlined in the contract. If one party becomes insolvent, the other party may have no recourse and could lose the value of its position.
Once created, the parties in a forward contract can offset their position with other counterparties, which can increase the potential for counterparty risks as more traders become involved in the same contract.
Swaps are another common type of derivative, often used to exchange one kind of cash flow with another. For example, a trader might use an interest rate swap to switch from a variable interest rate loan to a fixed interest rate loan, or vice versa. XYZ may be concerned about rising interest rates that will increase the costs of this loan or encounter a lender that is reluctant to extend more credit while the company has this variable rate risk.
Regardless of how interest rates change, the swap has achieved XYZ's original objective of turning a variable-rate loan into a fixed-rate loan. Swaps can also be constructed to exchange currency exchange rate risk or the risk of default on a loan or cash flows from other business activities.
Swaps related to the cash flows and potential defaults of mortgage bonds are an extremely popular kind of derivative. In fact, they've been a bit too popular in the past. It was the counterparty risk of swaps like this that eventually spiraled into the credit crisis of An options contract is similar to a futures contract in that it is an agreement between two parties to buy or sell an asset at a predetermined future date for a specific price.
The key difference between options and futures is that with an option, the buyer is not obliged to exercise their agreement to buy or sell. It is an opportunity only, not an obligation, as futures are. As with futures, options may be used to hedge or speculate on the price of the underlying asset. In terms of timing your right to buy or sell, it depends on the "style" of the option. An American option allows holders to exercise the option rights at any time before and including the day of expiration.
A European option can be executed only on the day of expiration. They believe the stock's value will rise in the future. However, this investor is concerned about potential risks and decides to hedge their position with an option. A strategy like this is called a protective put because it hedges the stock's downside risk. They believe its value will rise over the next month. In both examples, the sellers are obligated to fulfill their side of the contract if the buyers choose to exercise the contract.
However, if a stock's price is above the strike price at expiration, the put will be worthless and the seller the option writer gets to keep the premium as the option expires. If the stock's price is below the strike price at expiration, the call will be worthless and the call seller will keep the premium.
As the above examples illustrate, derivatives can be a useful tool for businesses and investors alike. They provide a way to do the following:. These pluses can often come for a limited cost. Derivatives can also often be purchased on margin , which means traders use borrowed funds to purchase them. This makes them even less expensive. Derivatives are difficult to value because they are based on the price of another asset.
The risks for OTC derivatives include counterparty risks that are difficult to predict or value. Most derivatives are also sensitive to the following:. These variables make it difficult to perfectly match the value of a derivative with the underlying asset. Since the derivative has no intrinsic value its value comes only from the underlying asset , it is vulnerable to market sentiment and market risk.
It is possible for supply and demand factors to cause a derivative's price and its liquidity to rise and fall, regardless of what is happening with the price of the underlying asset. Finally, derivatives are usually leveraged instruments, and using leverage cuts both ways. While it can increase the rate of return, it also makes losses mount more quickly.
Derivatives are securities whose value is dependent on or derived from an underlying asset. For example, an oil futures contract is a type of derivative whose value is based on the market price of oil.
Common examples of derivatives include futures contracts, options contracts, and credit default swaps. Beyond these, there is a vast quantity of derivative contracts tailored to meet the needs of a diverse range of counterparties.
It's important to note that regulations can vary somewhat, depending on the product and its exchange. In the currency market, for example, the trades are done via over-the-counter OTC , which is between brokers and banks versus a formal exchange. Two parties, such as a corporation and a bank, might agree to exchange a currency for another at a specific rate in the future.
Banks and brokers are regulated by the SEC. However, investors need to be aware of the risks with OTC markets since the transactions do not have a central marketplace nor the same level of regulatory oversight as those transactions done via a national exchange.
A commodity futures contract is a contract to buy or sell a predetermined amount of a commodity at a preset price on a date in the future. Commodity futures are often used to hedge or protect investors and businesses from adverse movements in the price of the commodity. For example, commodity derivatives are used by farmers and millers to provide a degree of "insurance.
Although both the farmer and the miller have reduced risk by hedging, both remain exposed to the risks that prices will change. For example, while the farmer is assured of a specified price for the commodity, prices could rise due to, for instance, a shortage because of weather-related events and the farmer will end up losing any additional income that could have been earned.
Likewise, prices for the commodity could drop, and the miller will have to pay more for the commodity than he otherwise would have. Let's use the story of a fictional farm to explore the mechanics of several varieties of derivatives.
Gail, the owner of Healthy Hen Farms, is worried about the recent fluctuations in chicken prices or volatility within the chicken market due to reports of bird flu. Gail wants to protect her business against another spell of bad news.
So she meets with an investor who enters into a futures contract with her. By hedging with a futures contract, Gail is able to focus on her business and limit her worry about price fluctuations. It's important to remember that when companies hedge, they're not speculating on the price of the commodity.
Instead, the hedge is merely a way for each party to manage risk. Each party has their profit or margin built into their price, and the hedge helps to protect those profits from being eliminated by market moves in the price of the commodity. Whether the price of the commodity moves higher or lower than the futures contract price by expiry, both parties hedged their profits on the transaction by entering into the contract with each other.
Derivatives can also be used with interest-rate products. Interest rate derivatives are most often used to hedge against interest rate risk. Interest rate risk can occur when a change in interest rates causes the value of the underlying asset's price to change. Loans, for example, can be issued as fixed-rate loans, same interest rate through the life of the loan , while others might be issued as variable-rate loans, meaning the rate fluctuates based on interest rates in the market. Some companies might want their loans switched from a variable rate to a fixed rate.
For example, if a company has a really low rate, they might want to lock it in to protect them in case rates rise in the future. Other companies might have debt with a high fixed-rate versus the current market and want to switch or swap that fixed-rate for the current, lower variable rate in the market. The exchange can be done via an interest-rate swap in which the two parties exchange their payments so that one party receives the floating rate and the other party the fixed rate.
Continuing our example of Healthy Hen Farms, let's say that Gail has decided that it's time to take Healthy Hen Farms to the next level. She has already acquired all the smaller farms near her and wants to open her own processing plant.
She tries to get more financing, but the lender , Lenny, rejects her. Lenny's reason for denying financing is that Gail financed her takeovers of the other farms through a massive variable-rate loan, and Lenny is worried that if interest rates rise, she won't be able to pay her debts. He tells Gail that he will only lend to her if she can convert the loan to a fixed-rate loan. Unfortunately, her other lenders refuse to change her current loan terms because they are hoping interest rates will increase, too.
Gail gets a lucky break when she meets Sam, the owner of a chain of restaurants. Sam has a fixed-rate loan about the same size as Gail's, and he wants to convert it to a variable-rate loan because he hopes interest rates will decline in the future. For similar reasons, Sam's lenders won't change the terms of the loan. Gail and Sam decide to swap loans.
They work out a deal in which Gail's payments go toward Sam's loan, and his payments go toward Gail's loan. Although the names on the loans haven't changed, their contract allows them both to get the type of loan they want.
The transaction is a bit risky for both of them because if one of them defaults or goes bankrupt , the other will be snapped back into their old loan, which may require payment for which either Gail or Sam may be unprepared.
However, it allows them to modify their loans to meet their individual needs. A credit derivative is a contract between two parties and allows a creditor or lender to transfer the risk of default to a third party. The contract transfers the credit risk that the borrower might not pay back the loan.
However, the loan remains on the lender's books, but the risk is transferred to another party. Lenders, such as banks, use credit derivatives to remove or reduce the risk of loan defaults from their overall loan portfolio and in exchange, pay an upfront fee, called a premium. Lenny, Gail's banker, ponies up the additional capital at a favorable interest rate and Gail goes away happy.
Lenny is pleased as well because his money is out there getting a return, but he is also a little worried that Sam or Gail may fail in their businesses. To make matters worse, Lenny's friend Dale comes to him asking for money to start his own film company.
Lenny knows Dale has a lot of collateral and that the loan would be at a higher interest rate because of the more volatile nature of the movie industry, so he's kicking himself for loaning all of his capital to Gail. Fortunately for Lenny, derivatives offer another solution. Lenny spins Gail's loan into a credit derivative and sells it to a speculator at a discount to the true value.
Although Lenny doesn't see the full return on the loan, he gets his capital back and can issue it out again to his friend Dale. Lenny likes this system so much that he continues to spin out his loans as credit derivatives, taking modest returns in exchange for less risk of default and more liquidity. Gail and Sam are both looking forward to retirement. Over the years, Sam bought quite a few shares of HEN. Sam is getting nervous because he is worried that another shock, perhaps another outbreak of bird flu, might wipe out a huge chunk of his retirement money.
Sam starts looking for someone to take the risk off his shoulders. Lenny is now a financier extraordinaire and active writer or seller of options, agrees to give him a hand. If the share prices plummet, Lenny protects Sam from the loss of his retirement savings. Healthy Hen Farms remains stable until Sam and Gail have both pulled their money out for retirement. Lenny profits from the fees and his booming trade as a financier. Lenny is OK because he has been collecting the fees and can handle the risk.
This tale illustrates how derivatives can move risk and the accompanying rewards from the risk-averse to the risk seekers. Although Warren Buffett once called derivatives "financial weapons of mass destruction," derivatives can be very useful tools, provided they are used properly.
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