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John Naronha

What are derivatives?

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A derivative is typically a financial contract whose value is derived from one or more underlying assets. Some of the key derivatives instruments include Futures, Forwards, Options, Swaps and Warrants and the most commonly used underlying assets are equities, index, interest rates, bonds, commodities, and currencies.

Typically, a derivatives contract is an agreement between a buyer and a seller where the buyer agrees to buy a specific quantity and quality of an asset on a specific date (maturity) and price (the price decided at the time of entering into the contract/agreement) and the seller agrees to deliver the same.

Derivatives instruments are broadly employed to hedge risk and to explore supplementary assets or markets and are traded  

  1. Over-the-counter (OTC)
  2. On a Derivatives Exchange

Some of the well-known derivatives exchanges are the Chicago Mercantile Exchange, London International Financial Futures and Options Exchange (LIFFE), Tokyo Financial Exchange (TFX), Singapore Mercantile Exchange (SMX), London Metal Exchange (LME), China Financial Futures Exchange (CFFEX), Eurex Exchange, National Stock Exchange of India (NSE), Korea Exchange etc.

OTC derivatives, on the other hand, are bilateral contracts or agreements made between two parties and therefore they are mostly unregulated, leaving them open to counterparty risk. On the other hand, derivatives traded on an exchange are standardized contracts which are primarily not subject to counterparty risk since clearing houses act as intermediaries and are governed by stringent regulations.

According to the Bank for International Settlements, the total notional value of outstanding derivatives contracts in the OTC markets stood at $595 trillion at the end of June 2018, largely driven by short-term US dollar interest rate derivatives.

For exchange-traded derivatives, the notional open interest in futures contracts across global exchanges was at $39.03 trillion at the end of December 2018 with an average daily turnover at about $8.1 trillion while the notional value of open interest in options accounted for $55.72 trillion at the end of December 2018 with the average daily turnover coming in at $1.76 trillion.

Following is an example of derivatives trading using options-

A company ABC is involved in the production of pre-packaged foods. They consume large quantities of flour and other commodities, which are generally prone to price volatility. If the company has to produce the product consistently and meet their bottom-line objectives, it has to purchase the required commodities at predictable and realistic prices. To do this, the company enters into a Wheat Options contract where the only cost to the company is the premium for the option it buys, but on the other hand, it is protected in the event of adverse price movements in the input cost. If the price of wheat rises in the interim, the company can exercise its option and purchase the asset at the strike price (predetermined price). However, if the company decides not to exercise the option and rather buy the underlying commodity from the primary markets, the seller of the option contract is free to sell the underlying asset to any other buyer. A derivatives contract can be a win-win situation for both the buyer and the seller, as the company is guaranteed a competitive price for the commodity while the producer is assured a fair value for the asset.

Like every other instrument, derivatives has its advantages and disadvantages. Mentioned below are some of the pros and cons of trading derivatives:

Advantages-

  • Hedging risk exposure- Since the price of a derivative is linked to the value of the underlying asset, derivatives are primarily used to hedge the underlying exposure by buying/shorting a derivatives contract. The gains/ losses in a derivatives transaction are generally offset by a conflicting transaction in the underlying asset.
  • Underlying asset price determination- Although the price of a derivative instrument is derived from the price of an underlying security, derivatives can sometimes be used to determine the price of the underlying asset in the future, based on certain future events.
  • Market efficiency- It is well established that derivatives increase the efficiency of financial markets. They provide a holistic approach as they provide advantages and benefits the organization, investors and the economy. By trading in derivatives, one can replicate the payoff of the underlying asset. Therefore, there is an equilibrium between the prices of the underlying asset and the associated derivatives.

Disadvantages-

  • High risk- Derivatives are leveraged products, and in the event of high volatility and large directional moves, traders can be subject to substantial financial risks, especially the over-leveraged ones. In addition, derivatives trading is a high-risk instrument which can lead to systemic losses resulting in the disruption of the global financial system; for instance, the market crash of 1987 and the financial crisis in 2008.
  • Speculative features- Derivatives are commonly regarded as tools for speculation. Due to the unpredictable behavior of markets, irrational speculation can lead to massive losses.
  • Counterparty risk- Although derivatives traded on exchanges are regulated, derivatives in OTC markets do not include specific benchmarks or regulators to monitor due diligence, making them a perfect candidate for counterparty risk.

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