Derivatives Explained

Mention derivatives and most people think of Nick Leeson, highly risky financial investments and Wall Street ‘wide boys’ making lots of money. However, 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.

What is a derivative

A Derivative is a financial instrument (e.g. Futures contract, Option) that is DERIVED from some other financial instrument that is known as the ‘underlying’ instrument.

For example: most people know about the Dow Jones Industrial Average which is reported constantly throughout the day. It is an indicator of whether the stock market is going up or down. You can ‘bet’ on the direction of the Dow buy buying or selling a ‘Futures’ contract on it. This Futures contract is a Derivative (as it derives from the Dow Index). If you think the market will go up by the end of the month you would buy the Dow Futures contract. If you think it will go down you would sell the futures contract. Whether you win or lose depends on the value of the Dow at the end of the month.

How are derivatives used

You can also get into derivatives of derivatives. For example you can buy or sell an ‘Option’ contract based on the Futures contract which is based on the underlying Dow Index.This is where many people start to get lost with the explanation so let me use a working example.

Airlines use derivatives to protect themselves against fluctuations in oil prices.

Oil prices can fluctuate greatly from month to month, meaning that if airlines bought oil at market price, the costs would also fluctuate greatly from month to month. Through the process of hedging, airlines greatly reduce their exposure to price fluctuations of oil. One of the ways that airlines do this is by buying call options.

An option is a unique financial contract between a buyer and a seller.

The holder or buyer of the option has the right, but not the obligation, to buy or sell the option’s underlying commodity or financial asset at a certain price (called the strike price) within a specific time period or at the end of that time period (called the expiration date). The expiration date will be sometime in the future of the day the contract is settled.

A call option gives the holder the right to buy the underlying asset, while a put option gives the holder the right to sell the underlying asset. A call option is only one of the many ways airlines can hedge against oil price volatility. Other hedging instruments include forwards/futures and swaps.

Swaps, forwards, futures and options

Swaps, forwards, futures, and options are all derivatives, or financial instruments whose values are “derived” from some underlying asset, which in this case is oil.

For example, if I buy a call option from you on oil with a strike price of $200 per ton, I have the right to buy the oil for $200 from you on the expiration date. In this case, let’s say the expiration date is 3 months in the future. At the end of 3 months, if the market price for oil goes up to $210 per ton, I can buy the oil from you for only $200 (called exercising the option), and you must deliver the oil. If the market price after 3 months is instead $190, I can let the option expire without exercising it.

Swaps and options have become the next most common form of derivative trading after the original futures.

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.

Swaps are, as the name suggests, an exchange of something. They 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.

Derivative history

As a testament to their usefulness, derivatives have played a role in commerce and finance for thousands of years. Derivatives contracts have been found written on clay tablets from Mesopotamia that date to 1750 B.C. Aristotle mentioned an option on the use of olive oil presses in his Politics some 2,500 years ago. The Japanese traded futures-like contracts on warehouse receipts or rice in the 1700s. In the U.S., forward and futures contracts have been formally traded on the Chicago Board of Trade since 1849.

Initially it was commodities like wheat or coffee which were the subject of such trading.

Traders bought and sold ‘future’ contracts – an agreement to buy coffee, say, in three months time at a certain price – protecting themselves from the worry that a crop failure might drive up the price of coffee in the intervening months.

In the 1980s, financial futures began to dominate trading. This involves buying and selling futures or options on shares, bonds or currencies.

Some investment bankers began to turn hedging into a profitable business in its own right, developing progressively complex ways of hedging.

And of course any tool, in the wrong hands can become a weapon. And financial derivatives are no exception.

The abuse of derivatives

The use of derivatives can result in large losses because of the use of leverage, or borrowing. Derivatives allow investors to earn large returns from small movements in the underlying asset’s price. However, investors could lose large amounts if the price of the underlying moves against them significantly. One of the most complicated derivatives and one which brought infamy to the word derivative is a collaterised debt obligation or CDO for short. You may have heard the letters CDO bounced around on the television a few years back when we had the subprime mortgage melt down.

So what is it all about? Well in simple terms our derivative is a piece of paper which supposedly “derives” its value from a real asset. For example, a mortgage on a house is such a piece of paper.

If I hold a mortgage on a house and the house maintains or increases its market value, and the owner services the mortgage, then I am happy.
However, I am also happy to sell that derivative to another person, thus avoiding any risk if the homeowner stops paying and/or the value of the house declines.
The person who buys mortgages may package and bundle those mortgages and other debts such as credit card loans and student loans and sell pieces to yet more investors, (these are essentially CDO’s) and so on, in a derivatives marketplace.

The US sub-prime mortgage crash

However, the ultimate holder of these loans or mortgages or piece of a mortgage has no way of knowing the market value of the mortgaged property, nor how that value may be changing.
So, to avoid that additional risk, the mortgages get sold and resold ad infinitum, building a massive “house of cards”. Meanwhile, the real house values are plunging, causing the value of derivatives to be undermined. This causes yet more “buck passing” to get rid of the “hot potato” mortgages.
Ultimately the game of musical chairs must stop, and the pile of mortgage paper collapses in a worthless heap and there we have the subprime crash of 2007/2008 albeit in its simplest form!

Derivatives are here to stay

But the baby should not be thrown out with the bathwater.  CDOs, and other derivative products serve a healthy and useful purpose towards the aim of creating more efficient financial markets – especially when it comes to hedging.

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 goods (metals, energy sources, agricultural produce etc.).

Using derivatives, the individual investor can make money when the market goes up or when it goes down, by predicting the direction of movement of the underlying asset.

Derivatives allow the sharing or redistribution of risk. They can be used to protect (hedge) against a specific exposure of a business (e.g. movements in asset price, exchange or interest rate, default of a creditor) or can be used by market participants to take on risk and speculate on the movement in the value of underlying assets, without ever owning the assets.

You must remember however derivatives behave like a two edged sword. If put to use wisely they work very effectively but when used recklessly can cause you severe agonies. Sadly there is no realistic way in which one could demarcate between the two. There is a very thin line that distinguishes gambling with a calculated taken risk.

Contact Me Today for an initial informal chat to look at ways in which I might be able to assist you with your current financial position.

About the author

Colin MacGregor is an independent financial advisor working across Europe for Professional Investment Consultants S.A. (Europe) www.pic-europe.com.

He has over 10 years experience in the advisory sector and currently resides in Prague, Czech Republic.