Introduction to Financial Derivatives
“By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives. These instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it - a process that has undoubtedly improved national productivity growth and standards of living.” -Alan Greenspan
Financial derivatives are financial instruments that “derive” value from an underlying item such as an asset or index. The use of derivatives provides exposure to the linked underlying item without necessitating the trade or exchange of the item itself. This allows specific risks, such as commodity or equity price fluctuations, to be traded in financial markets. Many derivatives are traded on exchanges such as the Chicago Mercantile Exchange(CME) or over the counter (OTC).
Derivative Uses
The main purposes of derivatives are risk control, arbitrage, and speculation. Derivatives allow risk of the underlying asset or index to be transferred between entities. This permits intermediary financial institutions and other entities that are more capable or knowledgeable about the specific risk to manage these risks.
For example, a corn farmer may enter into a derivative contract (normally a futures contract) to reduce risk from corn price fluctuation. If the farmer fears corn prices will fall below a hypothetical production price of $2 per bushel, the farmer may enter into a derivative contract with a merchant that agrees to purchase the corn at a specific price when the crop is harvested in a specific amount of time. In this case, assume the merchant agrees in the derivative contract to purchase corn at $2.5 per bushel. By utilizing derivatives, the farmer has guaranteed a corn sale price of $2.5 per bushel. If the price of corn decreases in the future, the value of the derivative contract increases as the farmer is able to sell corn above the market price. The use of the derivative allows the farmer to hedge the risk of a corn price decrease, and the speculator accepts this risk because of the possibility of a large reward if the price of the corn rises above $2.5 per bushel.
Derivatives are also used for arbitrage and speculation. Arbitrage is the practice of taking advantage of differences in price of the same asset in two or more markets. For example, if a commodity was being sold for a lower price in a rural area than in a city, the arbitrageur could purchase the lower cost commodity in the rural area and sell it at a higher price in the city. This example excludes extra costs, such as transportation costs, that are not present in “true” arbitrage that requires no additional risk. Derivative traders engaging in arbitrage may seek opportunities between different derivatives of identical or related securities. For example, if the price of a stock listed on the NYSE is different than the corresponding futures contract on the (CME) an arbitrageur could purchase the less expensive asset and sell the more expensive asset.
Enhanced exposure and reward potential are the primary reasons why derivatives are used for speculation. The use of options, for example allows for greater returns than the actual price movement of the underlying asset or index. For example, if a trader purchased a stock for $20 per share and the price increased to $40 per share, the trader would have a 100% return. If the same trader instead paid a $1 option premium to purchase the stock at $21 per share, the trader would have earned an 1800% return ((40-21-1)*100%). The use of derivatives allows for greater reward potential. In addition, derivatives allow traders or investors to gain exposure to underlying assets or indexes when the direct ownership of these underlying items is difficult.
Main Derivative Contract Types
Swaps - An agreement to exchange cash flows at a specified time according to certain rules.
Options - Contracts give holder the right but not the obligation to buy or sell an asset as a specific future date.
Futures - Contracts buy buy or sell an asset at a specific future date. Futures are essentially standardized forward contracts.
Forwards - An agreement to buy or sell an asset at a certain time in the future for a certain price.
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