Econ Grapher

Derivatives

What are derivatives?
Derivatives are financial contracts that derive their price based on an underlying asset or instrument. The point of derivatives is to enter into an arrangement that creates a type of exposure that meets the needs of either offsetting an existing exposure (hedging), or creating a new exposure based on a certain viewpoint (speculating). For example a person who thinks a stock price will go up may want to have the option to buy the stock if the price goes up, but not if the price goes down. This person would buy call options, paying a premium to gain the specific type of exposure to that market. Simply put derivatives are contracts or agreements that are based on certain things or assets (see the different types below). 

How does it relate to Markets?
Derivatives are a key instrument in financial markets, and contribute to the functioning and efficiency of a market. Derivatives allow investors to create particular positions based on their views about the economy, specific stocks, specific commodities, currencies, etc. Derivative prices can be particularly informative in forming strategy e.g. volatility metrics from option prices, and at the same time serve as excellent instruments to execute on strategy e.g. buying puts based on a view of falling prices, buying futures to take advantage of rising prices, etc.

Hedging vs Speculation
Most participants in derivatives markets are either hedging, speculating, or arbitraging:
Hedging - hedgers seek to eliminate exposure e.g. a company that needs to buy oil at a future date may enter a futures contract to eliminate price risk.
Speculating - speculators seek to make profits based on their view of prices; thus they want to create an exposure to price risk.
Arbitraging - arbitrageurs seek to make profits based on price differences between markets, thus they seek to quickly enter into offsetting positions at different prices to gain quick, usually small profits on large volumes, but not to retain risk.

Options
Options are the right but not the obligation to sell or buy a specified thing in a specified quantity, and price, and on a specified date. Options give you the advantage of the non-linear payoff profile i.e. one side of the market movements is limited e.g. with a call option (the option to buy), the buyer of the option has limited downside risk, but unlimited upside risk. The main drawback is the requirement to pay a premium (options are like insurance).

Futures
Futures are the obligation to buy or sell a certain thing in a certain quality, quantity and price at a certain date. Futures carry a hard obligation, but there is no requirement to pay a premium up front, however there is generally the requirement to post a margin or deposit in ones futures trading account to back the contract.

Swaps
Swaps involve the swapping of two payments at specified times, based on a specified notional principal, and based on a specified reference rate. For example the most common type of swap is the interest rate swap, where fixed payments are swapped for floating payments. A use of this would be a borrower who had floating rate debt, but feared rising interest rates; the borrower could enter into a swap contract to receive floating interest rate payments and pay fixed interest rate payments; the net position would leave the borrower net only paying fixed interest payments. Swaps can also be in reference to equity market returns, commodity market returns, and cross-currency, etc.

OTC vs Exchange
Derivatives are traded either OTC (over the counter) in informal markets e.g. between banks, investment banks, hedge funds, etc; or on an organized exchange. The key distinctions are: exchange traded contracts are standardized, are novated through a central counter party (clearing house... i.e. a strong 3rd party sits between the 2 parties to the derivative contract, thereby reducing default risk or counterparty risk), regulated, and highly transparent. Whereas OTC derivatives are non-standard, not transparent, traded directly with counter-parties, and sometimes not regulated. OTC markets can be less efficient, and there can be drawbacks due to the lack of transparency, but the upside is the non-standardization i.e. ability to create tailored and customized contracts to suit hedging or investment needs.

Sources and further reading:
RBNZ - A primer on derivatives markets
International Swaps and Derivatives Association, Inc.
The Journal of Derivatives
Derivatives Dictionary
Wikinvest - Derivatives

Graph Library:

Original Source: http://www.econgrapher.com/encyclopedia-derivatives.html

 Back to the Econ Grapher Encyclopedia

Bookmark and Share