Introduction to Derivatives

Humans have always been inventive through their sojourn in this world, and have come up with innumerable inventions that have made their lives comfortable. Sometimes though, they have done themselves, and their world, a lot of harm, with their inventions.

While many of the human inventions have fulfilled a genuine need, some inventions have served only their contrived needs, and yet others have catered to the baser instincts of man, primarily, greed.

Into which of these above categories does the financial instrument called “derivatives” fit in? Does it serve a genuine need or a contrived one, or only serves to pander to man’s greed? In the light of the present Banking crisis, said to be triggered by the housing mortgage crisis, it would appear that derivatives fall in the last category.

What is a Derivative? A derivative is a kind of financial instrument that does not have a value of its own, but derives it from an underlying base. This base may be an asset, or an index, or even a phenomenon. In a way,a derivative resembles a parasite that feeds off its host.

Derivatives do not have an independent existence of their own. They exist as offshoots of either assets like stocks, commodities, residential mortgages, etc. or indices relating to the stock market, consumer prices, exchange rates, etc., or even phenomena like the weather conditions. They derive their values from assets as described above.

Purpose and Scope: There are several purposes for which derivatives are put to use. Sometimes they are used to cover the risks associated with genuine business transactions, and sometimes for plain profit making. Sometimes it is dictated by necessity, sometimes by inclination. Some of the major purposes of using derivatives are:

Risk Management: The major purpose of having derivatives is to manage or counter risks faced in the business environment, especially that which cannot be dealt with conventionally. It is also called Hedging. Hedging occurs when the risk of the underlying asset is transferred through the medium of the derivative from one person to another. A forward contract in a foreign exchange transaction like export and import is an example of hedging.

Suppose an exporter of wheat based in Chicago exports a consignment of wheat to the United Kingdom, and expects the rate of the British Pound to decline against the U.S. Dollar, he may book a forward contract and sell his pounds at current rates against future delivery of wheat to the U.K.

Speculation: Another purpose for which derivatives are used may be to book extra profits, or profits out of the ordinary, by taking advantage of the favorable movement of the value of the underlying asset. Here the purpose of using derivatives is not hedging, or countering risk, but to scoop up additional profits. This activity is called speculation.

Arbitrage: Yet another purpose of derivatives is called as arbitrage, that is taking advantage of a lower current market value vis a vis, the future value of an asset. Whereas the use of derivatives to counter business risks related to genuine business transactions, may serve the purpose of utilizing derivatives, the same cannot be said of speculative activities, that have cause mayhem in the markets, more than once, in different parts of the world, notably the United States.

Types of Derivatives: Like there are two types of medicines, viz, over the counter, and prescription ones, so also there are basically two types of derivatives, the Over-The-Counter derivatives (OTD), and the Exchange-Traded-Derivatives (ETD).

Based on these two classes of derivatives, there are three kinds of them like Futures, Options, and Swaps, that are briefly discussed below.

Futures and Forwards: These are financial contracts with a commitment to buy or sell an asset within a certain future date at today’s price. That is future buy/sell at current rates. While a forward contract is an example of an OTC derivative, a futures contract is an example of an ETD.

Options: These are contracts that entitle their owner to either buy or sell an asset without imposing an obligation to do so (buy or sell). The option to buy relates to the call option and that to sell relates to the put option. The price of the transaction is fixed at the time of making the contract, and is referred to as the strike price. Another feature of this contract is the maturity date. Here again, there are two options- the European option, and the American option. Under the European option, the owner may specify maturity date only as date of Sale; whereas in the American option, Sale is allowed to take place on any date up to the maturity date.

Swaps: Under this type of contract, the underlying values of currencies, bonds, commodities, stocks etc., are exchanged on or before a specified future date.

As can be seen from the foregoing, derivatives may be used to either hedge one’s risk, or to make super profits, or just settle for arbitrage. As these instruments do not have a value of their own, they are vulnerable to any kind of shift or change in the value of the underlying. As such they may not be very reliable in countering risks unless the issues affecting the values of the underlying are properly understood and provided for.

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