Features and uses of Derivatives

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Features of derivatives:

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• Derivatives have a maturity date after which they terminate automatically, for example an option cannot be exercised after its maturity date.

• Derivatives, by themselves, have no independent value. Their value is derived out of the underlying instruments

• All the transactions in the derivative take place at a future specified date.

• Derivatives can be used as leverage instruments; big volumes can be traded with a small initial outlay of funds (small percentage of the entire contract value)

• There are no limits on the number of derivative contracts that can be transacted as there are no physical assets for transaction

• Derivatives improve the liquidity of the underlying instrument by performing the function of price discovery. The derivative market is therefore liquid.

 

Derivatives are used effectively as risk management tools because they shift the risk from the buyer of the derivative product to the seller.

 

Other uses include:

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• Hedging: Hedgers are risk-averse traders that seek an opposite position in the derivatives market to protect themselves against market risk and price fluctuations

• Speculating: Speculators are risk-loving traders who use derivatives to make quick money by taking advantage of high market volatility

• Arbitrage: Arbitrageurs carry out riskless trades when the same securities are being quoted at different prices in two markets. The simultaneous purchase of securities done in one market is matched by a corresponding sale in another market, allowing arbitrageurs to make profit.

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Commonly-Used Derivatives

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Futures

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A futures derivative is a contract that obligates the holder of the contract to buy the specified asset at a predetermined price at the expiration of the contract. The quality and quantity of the asset are standardised. Because this contract is exchange-traded, there is very high liquidity where delivery of the asset rarely occurs. Instead, traders generally ‘close out’ their position by taking the opposite position on the same contract. For example, a trader with a long position on a gold future will want to take a short position to essentially neutralise their position and cash out.

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Forwards

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A forwards derivative is a customised contract between two parties to buy or sell an asset at a predetermined price at some future date. The contract is traded over-the-counter and is not standardised. There will be deliverance of the asset or a cash settlement at expiration of the contract.

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Options

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An option acts in a very similar way to a futures contract, except the holder of the contract can choose whether or not to exercise it. However, the party with the short position is obligated to deliver if the option exercised. An option can be either a call option, which gives the contract holder the right to buy the asset at the specified price, or a put option, which gives the contract holder the right to sell the asset at the specified price. All options contracts are standardised and can further categorised based on the exercise period (on expiration, up to and including expiration).

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Swaps

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A swap is a derivative contract where two parties exchange the cash flows or liabilities of two different financial instruments. Usually, an unknown variable affecting the cash flows, such as interest rates, foreign exchange rates or future equity price is traded for a known variable such as fixed interest rates. Swaps are over-the-counter traded contracts and are not standardised.

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Case Study

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The fundamental issues of the Global Financial crisis (2007-8) lay in the housing market, specifically the subprime mortgage market and the proliferation of mortgage-backed securities. Buyers (typically investment banks) bought ownership of mortgages and bundled them into mortgage-backed securities (MBS), which would later be divided into a bond-like security before being sold to institutional investors. These financial instruments were extremely flexible with various tranches offering varying levels of risk and reward to its investors.

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It gets more complicated (and dangerous) when credit default swaps are involved. The financial derivative essentially serves as insurance for higher-risk loans, enabling reimbursements for borrowers in the case of defaults in exchange for an ongoing premium. It doesn’t eliminate the risks, but shifts such risks from the buyer to the CDS seller. Michael Burry, a hedge fund manager, found these highly risky, unstable mortgages and bet against them by going to banks and buying CDSs on mortgages. Many of the investment banks accepted, thinking that financial crisis was unlikely and thought that M.B’s monthly premium of millions was easy money.

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The banks were wrong, and M.B’s position grew as the value of MBSs declined due to increasing rates of defaults, while American mortgage holders, investment banks and the world economy lost big time. The financial chaos that ensued from rising default rates and the complex derivative securities also saw the downfall (and bankruptcy) of Lehman Brothers, previously the 4th largest investment bank in America. M.B’s renowned bet against the housing markets highlight the risks & reward associated with speculative derivative investments, with his CDS position arguably cemented as the greatest single investment (although Bill Ackman is knocking at door).