DERIVATIVES

A derivative is a contract between two or more parties whose value is based on an agreed-upon
underlying financial asset, index or security. Common underlying instruments include: bonds,
commodities, currencies, interest rates, market indexes and stocks.

Futures contracts, forward contracts, options, swaps and warrants are common derivatives. A futures
contract, for example, is a derivative because its value is affected by the performance of the underlying
contract. Similarly, a stock option is a derivative because its value is "derived" from that of the underlying
stock.

Derivatives are used for speculating and hedging purposes. Speculators seek to profit from changing
prices in the underlying asset, index or security. For example, a trader may attempt to profit from an
anticipated drop in an index's price by selling (or going "short") the related futures contract. Derivatives
used as a hedge allow the risks associated with the underlying asset's price to be transferred between the
parties involved in the contract.

For example, commodity derivatives are used by farmers and millers to provide a degree of "insurance."
The farmer enters the contract to lock in an acceptable price for the commodity; the miller enters the
contract to lock in a guaranteed supply of the commodity. Although both the farmer and the miller have
reduced risk by hedging, both remain exposed to the risks that prices will change. For example, while the
farmer locks in a specified price for the commodity, prices could rise (due to, for instance, reduced supply
because of weather-related events) and the farmer will end up losing any additional income that could
have been earned. Likewise, prices for the commodity could drop and the miller will have to pay more for
the commodity than he otherwise would have.

Some derivatives are traded on national securities exchanges and are regulated by the U.S. Securities and
Exchange Commission (SEC). Other derivatives are traded over-the-counter (OTC); these derivatives
represent individually negotiated agreement between parties.

A derivative is a financial contract with a value that is derived from an underlying asset. Derivatives
have no direct value in and of themselves -- their value is based on the expected future price movements
of their underlying asset.

HOW IT WORKS (EXAMPLE):

Derivatives are often used as an instrument to hedge risk for one party of a contract, while offeringthe
potential for high returns for the other party. Derivatives have been created to mitigate a remarkable
number of risks: fluctuations in stock, bond, commodity, and index prices; changes in foreign exchange
rates; changes in interest rates; and weather events, to name a few.

One of the most commonly used derivatives is the option. Let's look at an example:

Say Company XYZ is involved in the production of pre-packaged foods. They are a large consumer of
flour and other commodities, which are subject to volatile price movements.

In order for the company to assure any kind of consistency with their product and meet their bottom-line
objectives, they need to be able to purchase commodities at a predictable and market-friendly rate. In
order to do this, company XYZ would enter into an options contract with farmers or wheat producers to
buy a certain amount of their crop at a certain price during an agreed upon period of time. If the price of
wheat, for whatever reason, goes above the threshold, then Company XYZ can exercise the option and
purchase the asset at the strike price. Company XYZ pays a premium for this privilege, but receives
protection in return for one of their most important input costs. If XYZ decides not to exercise its option,
the producer is free to sell the asset at market value to any buyer. In the end, the partnership acts as a win-
win for both parties: Company XYZ is guaranteed a competitive price for the commodity, while the
producer is assured of a fair value for its goods.

In this example, the value of the option is "derived" from an underlying asset; in this case, a certain
number of bushels of wheat.

Other common derivatives include futures, forwards and swaps.

WHY IT MATTERS:

As often is the case in trading, the more risk you undertake the more reward you stand to gain.
Derivatives can be used on both sides of the equation, to either reduce risk or assume risk with the
possibility of a commensurate reward.

This is where derivatives have received such notoriety as of late: in the dark art of speculating through
derivatives. Speculators who enter into a derivative contract are essentially betting that the future price of
the asset will be substantially different from the expected price held by the other member of the contract.
They operate under the assumption that the party seeking insurance has it wrong in regard to the
future market price, and look to profit from the error.

Contrary to popular opinion, though, derivatives are not inherently bad. In fact, they are a necessity for
many companies to ensure profits in volatile markets or provide mitigated risk for everyday investors
looking for investment insurance.
Types of Derivatives

Derivatives are considered to be extremely risky. The market is divided in two fronts when it comes to
the opinion about risks involved in a derivative contract. Some people are of the opinion that since
derivatives are not new securities by themselves, how can they introduce new risk in the market? The
opposing camp agrees to this argument. However, they also state that derivatives are capable of
concentrating the risks in such a manner that the system cannot absorb them easily.

That being said, derivatives do create a wide variety of risks. Some of them have been discussed in
this article:

Counterparty Risk

About three quarters of the derivatives contracts across the world are entered over the counter. This means
that there is no exchange involved and hence there is a probability that the counterparty may not be able
to fulfill its obligations. This gives rise to the most obvious type of risk associated with derivatives market
i.e. counterparty risk.
Counterparty risks have many names. They are sometimes called legal risk, default risk, settlement risk
etc. Essentially all these risks refer to the same risk. When one party enters into an agreement with
another party, there is a chance that one of them may not follow through with the commitments. This
could happen at various stages. For instance, if the contract is not drafted then it would be called legal
risk. On the other hand, if the other party defaults on the day of the settlement, then it would be called
settlement risk. Hence, all these risks can be put together in one category called counterparty risk since all
of them pertain to willful or innocent default by the counterparty.

Price Risk

Derivatives being traded on the securities exchange are a relatively new phenomenon. Hence, all
participants including the most seasoned ones are clueless as to what should the pricing of these
derivatives be. The market is functioning in terms of superior knowledge relative to peers. Hence, there is
always a risk that the majority of the market may be mispricing these derivatives and may cause large
scale default. This has already happened in an infamous incident including the company called Long
Term Capital Management (LTCM). LTCM became part of a trillion dollar default and became a prime
example as to how even the smartest management may end up wrongly guessing the price of derivatives.

Agency Risk

A very less talked about problem pertaining to derivatives market is that of agency risks. Agency risk
simply means that if there is a principal and an agent, the agent may not act in the best interest of the
principal because their objectives are different from that of the principal. In this scenario it would mean
that if a derivative trader is acting on behalf of a multinational corporation or a bank, the interests of the
organization and that of the individual employee who is authorized to make decisions may be different.

This may seem like a small problem. However, if we consider what happened at companies like Barings
Bank and Proctor and Gamble then the true picture emerges.

Barings Bank was an industrial age bank that had a reputation that people could vouch for. However, as
the new age dawned, Barings Bank ventured into derivatives trading. They had a division that would
execute bets on behalf of the clients. Traders that could make successful bets were highly rewarded.

Amongst them was a trader named Nick Leeson who would later become famous as the rogue trader.

Nick Leeson used the banks own money and made huge bets in the derivatives market. For some time he
was making a profit. However, soon the size of his ambition grew and he siphoned off more money to the
derivatives market. Finally, the bets became so large that by the time the issue became apparent to the
senior management, Barings Bank was bankrupt! Nick Leeson had fled Singapore and was arrested and
sentenced to prison!
The above example clearly explains that kind of risks that organizations face when they allow traders to
make highly leveraged bets on their behalf. Also, since derivatives do not appear on the financial
statements, the management finds it difficult to keep track.

Of course, organizations have evolved a lot more since Nick Leesons era. Internal controls are extremely
strict and bets made by traders are closely monitored. However, the agency problem is still alive and
kicking. Any firm that wants to trade derivatives must pay close attention to and create a plan to mitigate
this risk.

Systemic Risk

Systemic risk pertaining to derivatives is widely spoken about. Yet it seems to be less understood and
almost never quantified. System risk refers to the probability of widespread default in all financial
markets because of a default that initially started in derivative markets. In simple words, this is the belief
that because derivatives are so volatile, one major default can cause cascading defaults throughout the
derivatives market. These cascading defaults will then spin out of control and enter the financial domain
in general 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 wasnt that silly and farfetched at all.

The logic behind this point of view is that most organizations dealing with derivatives have other
businesses too. Consider banks like JP Morgan and Goldman Sachs. They also have retail and corporate
banking businesses. However, in the event of a default, if banks like JP Morgan take huge losses in
derivatives markets, it may affect businesses on the main street as well.

Systemic risk pertaining to derivatives is not faced by any particular party. It is faced by the entire system.

At the present moment, regulation is being proposed as being the viable solution to this problem.
Regulators across the world are spending days and nights working out a plan that helps to reduce or evade
systemic risk.

Therefore, dealing with derivatives is largely about learning how to manage these risks effectively. The
market is never secure when such high leveraged investments are involved. Hence, when it comes to
derivatives, a vigilant trader is a good trader.
Understanding The Types Of Financial Derivatives

We have been hearing a lot of news about the financial market and financial derivatives. However, its
function still remains vague and abstract to many of us.

How do financial derivatives operate?

A financial derivative is a strategy that businesses and companies enter to reduce risks. It is a contract
entered by parties that creates a risk and benefit relationship to those involved. From the word itself, a
financial derivative is a derived value. This value comes forth from an underlying asset or index. Parties
then enter into a contract to be fulfilled at a certain date.

What are the types of financial derivatives?

The concept of financial derivatives is hard to grasp without concrete examples illustrating it. To fully
understand how financial derivatives work, let us take a look at the common forms or types of financial
derivatives.

1. Forward - This is a form of contract wherein two parties agree on buying or selling an asset at an
agreed price. The actual exchange then happens on a future date, thus the term forwards. The contract
happens among the parties themselves without an outside party interfering. The contract in a forward type
of financial derivative is non-standardized. It is subject to the choices of the parties engaged in a forward
contract.

2. Futures - A futures contract is similar in some manner to the forward type. It also involves an
agreement on sales of an asset on a future time. However, financial derivatives contracts of this category
have a standardized contract form. The terms and conditions of the contract are arranged by a third party
called a clearing house.

3. Options - This type of contract allow the person involved to have the option of exercising his right on
the assets. Transactions start at a specified price called a strike price. A maturity date is then set for the
owner to exercise his option of buying or selling the asset. The owner has the option of using his right on
the exact date of maturity and not before in a European option. The American option allows the owner to
exercise his right on or before the maturity date.

4. Swaps - Contracts involving swaps allow transactions to occur before a future date. Like all financial
derivative types, swaps derive their financial value based on the underlying asset.

The above examples are the most common forms of contracts on financial derivatives. There are many
other types that could be made out of a combination of the above examples. When these forms are
combined, the contract takes on new features or characteristics that are unique and different from the
other forms.

Knowing the types of financial derivatives makes it easier to understand how it works. Now that you
know the different contracts involved in financial derivatives, it will be easier to choose an option that
suits your need. The concept of financial derivatives may operate on an abstract level but its applications
and impact are definitely felt in the real world.