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Derivatives |
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| Mention derivatives to someone and see what happens. Eighty
percent will look blank and most of the rest will think of Nick Leeson, highly
risky financial investments and City 'wide boys' making lots of money. But,
insurance, farmers and complex mathematical formulas are as central to the
concept of derivatives as the rowdy dealing pits depicted in the Eddie Murphy
film Trading Places. |
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| Basics |
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 Derivatives are simply financial
instruments which derive their value from some underlying asset. The three
basic types are futures, options
and swaps.
There are derivatives on almost
all types of asset which are traded - the main four being bonds (which vary in
price according to interest rates), currencies, shares and what can broadly be
described as commodities (goods like metals, energy sources, agricultural
produce etc.).
Derivatives are generally traded on financial
exchanges, such as the Chicago Board of Trade (CBOT), or between banks on the
so called over-the-counter (OTC) market.
They are used as both a
type of insurance and as a way of making money. They are much more flexible
than the underlying products because they are simply a monetary value. The
value is based on the price of the underlying product, but most contracts are
settled in cash terms.
This enables banks, traders or investors
such as George Soros to bet on price movements without having to deal with the
actual assets. They could gamble, for example, on the frozen concentrated
orange juice crop without having to buy an orange grove.
Derivatives can also be 'leveraged' - that is geared up to be
worth many times the value of the underlying - so that if the price of the
asset moves $1, the value of derivative could change by $10. This simulates
owning a lot of the asset.
These instruments can also be used to
insure against adverse price moves. In simple terms, an investor can buy a
derivative which bets that the market will move against them so that they can
ensure some sort of profit, whatever happens. Swaps and options are the main
instruments for firms who wish to avoid risk.
 The image of derivatives as highly risky investments stems
from the fact that all contracts are traded on Margin. Margin is a
deposit, typically 10%, that covers most outcomes of a contract. So to buy a
$1,000,000 orange juice derivative you might only need to put up
$100,000 because the price is unlikey to move more than 10% against you. Thus
you can buy and sell much more than you would otherwise be able to
afford.
Usually the market will not move that much and the
contract will be settled or sold to somebody else for a small gain or loss.
However if it does shift significantly big losses can be incurred.
Banks have complex computer programmes to tell them how much
they could lose if the market moves by a certain amount. Regulations require
them to put money aside to protect against possible losses.
On
exchanges, traders have to pay any losses incurred on their position at the end
of each day. This "margin" payment is to prevent risks getting out of hand.
The question of how Nick Leeson was able to make the margin
payments without setting off the warning lights was raised in various inquiries
but never answered. It is a crime that he was the only person jailed for the
crime. Many others were at fault and more fundamentally serious. |
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| Futures |
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 The original derivative was a future used by farmers to set
the price of their produce in advance. Before they started sowing they would
make a deal to sell their goods at a certain price come harvest time.
This enabled them to work out how much they could spend on planting and
tending their crops. After the harvest, goods would be sold at the pre-agreed
price no matter what the movements of the market.
Sometimes the
future contract would earn a profit compared to the market price, other times
it would generate a loss - but it allowed the farmer to eradicate uncertainty.
Futures on agricultural goods, metals, oil and gas, bonds and
currencies are traded on exchanges round the world.
The value of
a future is determined by the relationship between the price set in the
contract and the market price, the length of time until the contract is due -
and supply and demand in the market.
Futures contracts specify
the quality, quantity and location for goods to be delivered, but not many are
used to actually sell goods.
Most are settled by cash payment on
the date that delivery is due, with the holder paying or receiving the
difference between the price set in the contract and the market price.
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| Options |
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 Options were invented because people liked the security of
knowing they could buy or sell at a certain price, but wanted the chance to
profit if the market price suited them better at the time of delivery.
So for a certain fee - called the premium - an option gave them the
right, but not the obligation, to buy or sell at a certain price.
An option to sell, known as a put option, would only be
exercised if the price set in the futures contract was higher than the market
price at the time of harvest, and vice versa for an option to buy (call
option). This means if the market price rises then you exercise your right
to buy at the agreed price and then immediately sell at the market price, thus
netting a profit.
Working out the cost of an option is very
complicated. There are many pricing mechanisms in use, most involving complex
mathematical formulas.
The most famous options pricing model is
known as Black-Scholes. There are also many different types of option - from
knock-ins and knock-outs to barrier, binary and Asian options - most of which
vary either the time or the price at which the options can be exercised.
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| Swaps |
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 Swaps are, as
the name suggests, an exchange of something. They are generally carried out on
the interbank OTC market.
Swaps are generally done on interest
rates or currencies. For example a firm may want to swap a floating interest
rate for fixed interest rate to minimise uncertainty.
Swaps come
in all shapes and sizes. The most basic variation being a swaption - which is
an option on a swap. |
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