Derivatives are not an entity that is completely new – in fact their history can be traced back to the second millennium BC in Mesopotamia. But as a financial instrument, derivative was not being used until the 1970s. The advancement in valuation strategies led to rapid growth of derivatives, and today it is difficult to contemplate the financial sector without their presence.
Derivatives enable traders to estimate future cash flows. This aids companies to forecast their earnings effectively ie. the predictability encourages positive trends for stock prices.
Many of the worlds biggest companies utilize derivatives to lower the risk of their overall transactions. For instance, a futures contract can be used to fulfill future purchases for an agreed upon price. This ensures that in case of scenarios where there is a price rise, the company is protected from the rising costs. Another way contracts help companies is that they can protect them from fluctuations in exchange rates and interest rates.
The majority of derivative trading is carried out by hedge funds and investors to enable them to have leverage in trading. Derivatives tend to need just a small amount of down payment ie. paying on margin. In many cases, derivative contracts can be offset or liquidated by another derivative before coming to term.
Types of Derivative Contracts
- – Options: Optionsare derivative contracts which permit the buyer to buy or sell the underlying asset at a fixed price for a fixed time period, but the buyer does not have to exercise this option. The fixed price is known as the strike price.
- – Futures: Futuresare standardized contracts which enable the holder to purchase or sell at an agreed price at a set date. Unlike options, both the parties in this case are obligated to fulfill the contract. The contract value for futures is adjusted based on the market changes till the expiration date. The most popular futures contracts are commodities futures and the most important commodities are the oil price futures. They fix the prices of oil and then gasoline.
- – Forwards: Forwardscan be considered as future contracts where the holder is under an obligation to perform the control. Forwards are not standardized and are not traded based on stock exchange. These contracts can be customized to suit the needs of both parties ie. they can customize the underlying commodity, its quantity, and the date of transaction. Forwards and futures have a very similar nature.
- – Swaps: Swaps are derivative contracts where the two trading parties exchange their financial obligations. The amount of cash traded is based on the rate of interest, ie. one cash flow is fixed and the other cash flow changes based on the basis of benchmark interest rate. The most popular swaps tend to be the interest rate swaps, commodity swaps and currency swaps. Swaps are not traded on stock exchanges but are transactions between businesses or financial institutions. For eg. an investor might sell his stock in the US, and purchase it in foreign currency and this helps him to limit the currency risk. These are over the counter (OTC) options ie. derivatives that are traded between two parties that are known to one another, or could also be traded through organizations such as banks.
Risks associated with Derivatives
- – One of the largest risks relevant with derivatives is the fact that traders cannot know their real value. Derivativesare directly associated with one or more assets, and their complex nature makes it difficult for traders to access their price. For eg. mortgage-backed securities, the computer programmers who developed them were not aware of their pricing when the housing market took a price hit. Banks were reluctant to trade derivatives as they could not accurately place a value for them.
- – The second risk associated with derivativesis leverage. For instance traders involved in futures need to put 2 to 10% of the contract value in a margin account to maintain their ownership. If the value of the asset drops the trader needs to add money to the margin account to maintain the percentage until the contract expires.
- – The third risk is the time constraint associated with derivatives, for eg. one might be able to estimate that gas prices will be on the rise but there is no way for any trader to know the exact timing for any event to take place.
A large number of the worlds biggest 500 companies tend to use derivatives to lower their risk while trading. In 2017, there were approximately 25 billion derivative contracts that were traded between companies. There are four types of derivative contracts – options, futures, forwards and swaps. Companies or traders can decide to use which contract is most apt for their situation, while monitoring the market and weighing the risks involved for the trade.