Introduction to Derivatives

Human beings have always been inventive during their stay in this world, and have come up with countless inventions that have made their lives more comfortable. Sometimes, however, they have done a lot of damage to themselves and their world with their inventions.

While many of human inventions have satisfied a genuine need, some inventions have served only their artificial needs, and others have satisfied man’s basic instincts, primarily greed.

In which of the above categories does the financial instrument called “derivatives” fit? Does it serve a genuine or artificial need, or does it serve only to gratify man’s greed? In light of the current banking crisis, which is said to have been triggered by the home foreclosure crisis, it would seem that derivatives fall into the latter category.

What is a Derivative? A derivative is a type of financial instrument that does not have a value of its own, but is derived from an underlying basis. This basis can be an asset, an index, or even a phenomenon. In a way, a derivative resembles a parasite that feeds on its host.

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

Purpose and scope: There are various purposes for which derivatives are used. They are sometimes used to hedge the risks associated with genuine business transactions, and sometimes for profit. Sometimes necessity dictates, sometimes inclination. Some of the main purposes of using derivatives are:

Risk management: The main purpose of holding derivatives is to manage or offset the risks faced by the trading environment, especially those that cannot be dealt with in a conventional manner. Also called Hedge. Hedging occurs when the risk of the underlying asset is transferred through the derivative from one person to another. A forward contract in a foreign exchange transaction such as export and import is an example of hedging.

Suppose a Chicago-based wheat exporter exports a shipment of wheat to the UK and expects the British pound’s exchange rate to decline against the US dollar, he can book a forward contract and sell his pounds at the current exchange rate. against future delivery of wheat to the UK

Speculation: Another purpose for which derivatives are used may be to record extra profits or unusual profits, taking advantage of the favorable movement in the value of the underlying asset. In this case, the purpose of using derivatives is not to hedge or offset risk, but to gain additional profit. This activity is called speculation.

Arbitration: Yet another purpose of derivatives is called arbitrage, which is to take advantage of a lower current market value versus the future value of an asset. While the use of derivatives to offset business risks related to genuine business transactions may be for the purpose of using derivatives, the same cannot be said for speculative activities that have caused chaos in the markets, more than once, in different parts of the world. of the world. , particularly the United States.

Types of Derivatives: Just as there are two types of drugs, namely over-the-counter and prescription drugs, there are also basically two types of derivatives, OTC derivatives (OTDs) and exchange-traded derivatives (ETDs).

Based on these two classes of derivatives, there are three types of derivatives, such as futures, options and swaps, which are briefly discussed below.

Futures and Forwards: They are financial contracts with a commitment to buy or sell an asset within a specified future date at today’s price. That is future buy/sell at current rates. While a forward contract is an example of a military cadet corps derivative, a futures contract is an example of a and d

Options: These are contracts that give the owner the right to buy or sell an asset without imposing an obligation to do so (buy or sell). The call option is related to the call option and the put option is related to the put option. The transaction price is set at the time of entering into the contract and is called the strike price. Another feature of this contract is the expiration date. Here again, there are two options: the European option and the American option. Under the European option, the owner can specify the expiration date as the Sell date only; while in the American option, the sale is allowed to take place on any date up to the expiration date.

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

As you can see from the above, derivatives can be used to hedge one’s risk, to make windfall profits, or simply to settle for arbitrage. As these instruments do not have a value of their own, they are vulnerable to any type of movement or change in the value of the underlying. As such, they may not be very reliable in offsetting risks unless issues affecting underlying values ​​are properly understood and anticipated.