Table of Contents:-
- Financial Derivatives: Instruments, Origins, and Ongoing Debates
- The Role of Financial Derivatives in Evolving Investment Strategies
- Features of Financial Derivatives
- Types of Financial Derivatives
- Uses of Financial Derivatives
- Economic Functions of Financial Derivative Contracts
- Disadvantages of Financial Derivatives
- Risk Involved in Financial Derivatives
- The Rise of Financial Derivatives in a Globalized Economy
Financial Derivatives: Instruments, Origins, and Ongoing Debates
The term financial derivatives encompasses a variety of financial instruments, including stocks, bonds, treasury bills, interest rates, foreign currencies, and other hybrid securities. This category includes futures, forwards, options, swaps, and more, with futures contracts being the most significant form, predating the coining of the term ‘derivative.’ Financial derivatives can be derived from a variety of cash market instruments or different financial derivative instruments. Contrary to being revolutionary, most financial derivatives are combinations of older-generation derivatives and standard cash market instruments.
In the 1980s, financial derivatives were known as off-balance sheet instruments because no underlying asset or liability was recorded on the balance sheet. Their value depends on the movement of market prices of underlying assets, treating them as contingent assets or liabilities. The inclusion of off-balance sheet instruments in the definition of derivatives is a matter of considerable debate, raising questions about which items or products listed on the balance sheet should be considered derivatives.
In essence, the term ‘financial market derivative’ is defined as a treasury or capital market instrument derived from, or closely related to, a cash instrument or another derivative instrument. Therefore, financial derivatives are financial instruments whose prices are derived from the prices of other financial instruments.
The Role of Financial Derivatives in Evolving Investment Strategies
The objective of an investment decision is to achieve the required rate of return with minimal risk. In recent years, various instruments, practices, and strategies have been devised and developed to meet this objective. With the opening of boundaries for international trade and business, global trade gained momentum in the last decade, ushering the world into a new phase of global integration and liberalization. The integration of capital markets worldwide has led to increased financial risk due to frequent changes in interest rates, currency exchange rates, and stock prices. To overcome the risk arising from these fluctuating variables and the increased interdependence of capital markets among different countries, risk management practices have also evolved. New instruments, such as financial derivatives, have been invented to mitigate the risk element. These popular instruments not only reduce financial risk but also present new opportunities for high-risk takers.
Features of Financial Derivatives
Features of Financial Derivatives are as follows:
Derives Value from Underlying Asset
Typically, derivative instruments derive their worth from the values of other underlying assets, including agricultural commodities, metals, financial assets, intangible assets, etc. The value of derivatives is contingent upon the value of the underlying instrument, which fluctuates with changes in the underlying assets. At times, this value may be nil or zero. Hence, they are closely related.
It is a Contract
A derivative is defined as a future contract between two parties. This implies that there must be a contract binding the underlying parties, and it is to be fulfilled in the future. The duration of the future period may be short or long, depending on the nature of the contract. For example, there are short-term interest rate futures and long-term interest rate futures contracts.
Direct or Exchange-Traded
Derivatives contracts can be undertaken directly between two parties or through a specific exchange, such as financial futures contracts. Exchange-traded derivatives are quite liquid and have low transaction costs compared to tailor-made contracts. Examples of exchange-traded derivatives include Dow Jones, S&P 500, Nikkei 225, NIFTY options, and S&P Junior, which are traded on the New York Stock Exchange, Tokyo Stock Exchange, National Stock Exchange, Bombay Stock Exchange, and so on.
Generally, the counterparties have specified obligations under the derivative contract. Naturally, the nature of the obligation would vary based on the type of derivative instrument. For instance, the obligations of the counterparties under different derivatives, such as forward contracts, futures contracts, option contracts, and swap contracts, would differ.
Delivery of Underlying Asset Not Involved
Typically, in derivatives trading, the taking or making of delivery of underlying assets is not involved. Instead, underlying transactions are mostly settled by taking offsetting positions in the derivatives themselves. Therefore, there is no effective limit on the quantity of claims that can be traded in respect of underlying assets.
Related to Notional Amount
Generally, financial derivatives are carried off-balance sheet. The size of the derivative contract depends on its notional amount. The notional amount is the figure used to calculate the payoff. For example, in an options contract, the potential loss and potential payoff may differ from the value of the underlying shares, as the payoff of derivative products varies from what their notional amount might suggest.
Secondary Market Instruments
Derivatives are primarily secondary market instruments and have limited usefulness in mobilizing fresh capital for the corporate world. However, warrants and convertibles are exceptions in this respect.
May Be Used as Deferred Delivery
Derivatives are also known as deferred delivery or deferred payment instruments. This implies that taking short or long positions in derivatives is easier compared to other assets or securities. Furthermore, it is possible to combine them to meet specific requirements; in other words, they are more easily amenable to financial engineering.
Off-Balance Sheet Item
Lastly, derivative instruments, at times, due to their off-balance sheet nature, can be used to tidy up the balance sheet. For example, a fund manager who is restricted from holding a particular currency can buy a structured note whose coupon is tied to the performance of a specific currency pair.
Exposure to Risk
While standardized, general, and exchange-traded derivatives are increasingly evolving in the market, there still exist numerous privately negotiated customized, over-the-counter (OTC) traded derivatives. These expose the trading parties to operational risk, counterparty risk, and legal risk. Additionally, there may be uncertainty about the regulatory status of such derivatives.
Types of Financial Derivatives
Derivatives come in two types: financial and commodities.
One form of classifying derivative instruments is between commodity derivatives and financial derivatives. The fundamental difference between them lies in the underlying instrument or asset. In a commodity derivative, the underlying instrument is a commodity, which may include wheat, cotton, pepper, sugar, jute, turmeric, corn, soybeans, crude oil, natural gas, gold, silver, copper, and so on. In a financial derivative, the underlying instrument may be treasury bills, stocks, bonds, foreign exchange, stock indices, gilt-edged securities, cost-of-living indices, etc. It is worth noting that financial derivatives are fairly standardized with no quality issues, whereas, in commodity derivatives, the quality of the underlying matter may be a consideration. However, despite the distinction in structure and functioning, both are almost similar.
The most commonly used derivative contracts are forwards, futures, and options.
A forward contract is a customized agreement between two entities where settlement occurs on a specific future date at a pre-agreed price determined today. For instance, consider an Indian car manufacturer purchasing auto parts from a Japanese car maker with a payment of one million yen due in 60 days. Facing a shortage of yen and anticipating a possible increase in its value to Rs. 70 over the next 60 days, the Indian importer can hedge this exchange risk by arranging a 60-day forward contract with a bank for Rs. 70. As per the forward contract, in 60 days, the bank will provide the importer with one million yen, and the importer will pay the bank 70 million rupees.
A futures contract is an agreement between two parties to buy or sell an asset at a specified time in the future at a predetermined price. Futures contracts differ from forward contracts in that they are standardized, exchange-traded agreements. For instance, suppose a speculator anticipates an increase in the price of gold from the current future price of Rs. 9,000 per 10 grams. Considering a market lot of 1 kilogram, the speculator purchases one lot of future gold (9000 × 100), amounting to Rs. 900,000. Assuming a 10% margin money requirement and a 10% increase in the price of gold, the transaction’s value will also increase to Rs. 9,900 per 10 grams, resulting in a total value of Rs. 990,000. In other words, the speculator earns 90,000 Rupees.
Options come in two different types: calls and puts. Calls grant the buyer the right, but not the obligation, to purchase a specified quantity of the underlying asset at a predetermined price on or before a specified future date. Puts, on the other hand, provide the buyer with the right, but not the obligation, to sell a designated quantity of the underlying asset at a predetermined price on or before a fixed date in the future.
Options typically have a lifespan of up to one year, with the majority of options traded on options exchanges having a maximum maturity of nine months. Options with longer durations are referred to as warrants and are generally traded over the counter.
LEAPS stands for Long-Term Equity Anticipation Securities. These are options with a maturity of up to three years.
Basket options are financial instruments that derive their value from portfolios of underlying assets. Index options can be considered a specific form of basket options.
Swaps are private agreements between two parties aimed at exchanging future cash flows based on a predetermined formula. They can be regarded as collections of forward contracts. The two commonly used types of swaps are:
- Interest Rate Swaps: These involve swapping only the interest-related cash flows between the parties in the same currency.
- Currency Swaps: These involve swapping both principal and interest in a different currency than those in the opposite direction.
Swaptions are options to buy or sell a swap that becomes operative at the expiry of the options. Therefore, a swaption is an alternative to a forward swap. Instead of calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating, while a payer swaption is an option to pay fixed and receive floating.
Uses of Financial Derivatives
Derivatives are intended to offer the following services:
Prediction of future prices
Derivatives serve as barometers of future trends in prices, leading to the discovery of new prices in both spot and futures markets. They also play a role in disseminating information about futures market trading for various commodities and securities to society. This, in turn, helps in the discovery of suitable, correct, or true equilibrium prices in the markets. As a result, derivatives contribute to the appropriate and superior allocation of resources in society.
Risk aversion tools
One of the most important services provided by derivatives is the ability to control, avoid, shift, and manage various types of risks through strategies such as hedging, arbitraging, spreading, etc. Derivatives help holders effectively modify the risk characteristics of their portfolios. They are particularly useful in highly volatile financial market conditions, such as erratic trading, highly flexible interest rates, volatile exchange rates, and monetary chaos.
Derivatives help investors, traders, and managers of large pools of funds devise strategies to make proper asset allocations, increase yields, and achieve other investment goals.
In derivatives trading, there is no immediate requirement for the full amount of the transaction, as most of them are based on margin trading. Consequently, a large number of traders, speculators, and arbitrageurs operate in such markets. Therefore, derivatives trading enhances liquidity and reduces transaction costs in the markets for underlying assets.
Catalyze growth of financial markets
Derivative trading encourages competitive activity in the markets, reflecting various risk preferences among market operators such as speculators, hedgers, traders, and arbitrageurs. This leads to an increase in trading volume within the nation. Derivatives also attract young investors, professionals, and other experts, acting as catalysts for the growth of financial markets.
Brings perfection to the market
Finally, it is observed that derivatives trading contributes to the development of the market towards a ‘complete market.’ The concept of a complete market refers to a situation where no particular investor can be better off than others, and the patterns of returns for all additional securities are spanned by the already existing securities, leaving no further scope for additional securities.
Integration of price structure
Derivatives trading in the market has been observed to smooth out price fluctuations, narrow price spreads, integrate price structures at different points in time, and alleviate gluts and shortages in the markets.
Economic Functions of Financial Derivative Contracts
Derivative contracts serve various economic functions. Key functions can be outlined as follows:
Price discovery function:
This refers to the ability to achieve and disseminate price information. Without price information, investors, consumers, and producers cannot make informed decisions. They are unable to allocate their capital efficiently. Derivatives are exceptionally well-suited for providing price information. They are the tools that assist everyone in the marketplace in determining value. The wider the use of derivatives, the broader the distribution of price information.
Risk management functions
This is the major function of derivatives. Derivatives shift the risk from the customer of the derivative product to the salesperson. Thus, derivatives are very effective risk management tools. Most of the world’s 500 largest companies use derivatives to lower risk.
Derivatives significantly enhance market liquidity, leading to lower transactional costs, increased efficiency in doing business, and expanded opportunities for raising capital investment.
Derivative contracts improve the liquidity of the underlying instruments. They provide better avenues for raising money and contribute to sustaining the increasing depth of the markets. Derivative markets often exhibit greater liquidity than spot markets. This increased liquidity is at least partly attributed to the smaller amount of capital required for participation in derivative markets. With lower capital requirements, more participants can engage in the market. This leads to an increased volume of trade and liquidity.
Economic Development Function
Derivative markets attract bright, creative, and well-educated individuals with an entrepreneurial attitude. These markets energize others to establish new businesses, develop innovative products, and create new employment opportunities. Additionally, derivative markets contribute to the growth of savings and long-term investments.
Portfolio Management Function
Derivatives contribute to efficient portfolio management by enabling better diversification with a smaller fund. They offer a broader range of options to portfolio managers who are always seeking an improved risk-return trade-off.
Disadvantages of Financial Derivatives
Disadvantages of Financial Derivatives are as follows:
In the case of mutual funds or shares, one can manage with limited knowledge about their sector of trading. However, in the case of derivatives, it is challenging to sustain in the market without expert knowledge in the field.
The main issue with derivative contracts is their limited lifespan. As time passes, the value of the derivatives will decline, posing a risk of potential complete loss within the agreed time frame. The main issue with derivative contracts is their limited lifespan. As time passes, the value of the derivatives will decline, posing a risk of potential complete loss within the agreed time frame.
Since the value of derivatives is based on underlying assets such as commodities, metals, and stocks, they are exposed to high risk. Most derivatives are traded on the open market, and the prices of these commodities, metals, and stocks are continuously changing. Consequently, the risk of losing their value is very high.
Risk Involved in Financial Derivatives
Risks involved in Financial Derivatives are as follows:
Derivatives, which are traded on the securities exchange, represent a relatively recent development. Hence, all participants, including the most seasoned ones, are clueless as to what the pricing of these derivatives should be. The market is functioning with a disparity in knowledge among participants. Hence, there is always a risk that the majority of the market may misprice these derivatives and cause large-scale defaults. This has already happened in an infamous incident involving the company known as Long Term Capital Management (LTCM). LTCM became involved in a trillion-dollar default, serving as a prime example of how even the most astute management can end up incorrectly assessing the value of derivatives.
Approximately three-quarters of derivatives contracts worldwide are traded over the counter, meaning there is no exchange involved, and there is a probability that the counterparty may not be able to fulfil its obligations. This gives rise to the most noticeable type of risk related to the derivatives market, namely, counterparty risk.
Systemic risk related to derivatives is frequently discussed, yet it appears to be less understood and rarely quantified. Systemic risk refers to the probability of widespread default in all financial markets due to a default that initially started in derivative markets. In simple terms, this belief suggests that because derivatives are so volatile, one major default can trigger cascading defaults throughout the derivatives market. These cascading defaults can then spiral out of control and enter the broader financial domain, threatening the existence of the entire financial system. This view has been prevalent for a long time; however, it was often dismissed as a silly doomsday prediction. In 2008, most people found out that it wasn’t that silly and far-fetched at all.
A lesser-discussed issue in the derivatives market is that of agency risks. Agency risk refers to the situation where, in the presence of a principal and an agent, the agent may not act in the best interest of the principal due to differing objectives. In this context, if a derivative trader is representing multinational companies or a bank, the interests of the organization and those of the individual employee authorized to make decisions may misalign. This may seem like a minor problem; however, considering what happened at companies like Barings Bank and Proctor and Gamble, the true picture emerges.
The Rise of Financial Derivatives in a Globalized Economy
The past decade has witnessed significant growth in international trade and business, driven by the waves of globalization and liberalization worldwide. Consequently, there has been a substantial increase in the demand for international money and financial instruments on a global scale. However, this surge in activity has also led to heightened financial risks for businesses, with changes in interest rates, exchange rates, and stock market prices impacting financial markets differently.
To address and manage these risks, new financial instruments, commonly referred to as financial derivatives, have emerged in the financial markets. These instruments aim to provide price commitments for future dates, offering protection against adverse movements in future prices and reducing the extent of financial risks. Moreover, they create opportunities for profit for those willing to take on higher risks, essentially facilitating the transfer of risk from risk-averse parties to risk-tolerant ones.
Financial derivatives have gained widespread popularity and are now integral in the world of finance. Often termed the “derivatives revolution,” the market has experienced phenomenal growth globally. The current annual trading volume of derivative markets is estimated to surpass US $30,000 billion, exceeding 100 times the gross domestic product of India.
Key financial derivatives, such as futures, forwards, options, and swaps, play a crucial role in managing assets, portfolios, and financial risks. Understanding the terminology and conceptual framework of these instruments is essential for effective analysis and risk management. The prices of financial derivatives contracts are influenced by factors such as spot prices of underlying assets, costs of carrying assets into the future, and their relationship with spot prices. For example, while forward and futures contracts share similarities, their future prices may differ. Therefore, traders and investors must thoroughly examine all relevant aspects before utilizing financial derivative instruments for hedging, speculating, or arbitraging purposes.