Question

Explain why derivatives are, as Partnoy says, "a horror show." How can we make derivatives less dangerous and frightening? Or should they be abolished altogether?

Answer 1

What Is a Derivative?

A derivative is a financial security with a value that is reliant upon or derived from, an underlying asset or group of assets—a benchmark. The derivative itself is a contract between two or more parties, and the derivative derives its price from fluctuations in the underlying asset.

The most common underlying assets for derivatives are stocks, bonds, commodities, currencies, interest rates, and market indexes. These assets are commonly purchased through brokerages.

Derivatives can trade over-the-counter (OTC) or on an exchange. OTC derivatives constitute a greater proportion of the derivatives market. OTC-traded derivatives, generally have a greater possibility of counterparty risk. Counterparty risk is the danger that one of the parties involved in the transaction might default. These parties trade between two private parties and are unregulated.

Conversely, derivatives that are exchange-traded are standardized and more heavily regulated.

The Basics of a Derivative

Derivatives can be used to hedge a position, speculate on the directional movement of an underlying asset, or give leverage to holdings. Their value comes from the fluctuations of the values of the underlying asset.

Originally, derivatives were used to ensure balanced exchange rates for goods traded internationally. With the differing values of national currencies, international traders needed a system to account for differences. Today, derivatives are based upon a wide variety of transactions and have many more uses. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a region.

For example, imagine a European investor, whose investment accounts are all denominated in euros (EUR). This investor purchases shares of a U.S. company through a U.S. exchange using U.S. dollars (USD). Now the investor is exposed to exchange-rate risk while holding that stock. Exchange-rate risk the threat that the value of the euro will increase in relation to the USD. If the value of the euro rises, any profits the investor realizes upon selling the stock become less valuable when they are converted into euros.

To hedge this risk, the investor could purchase a currency derivative to lock in a specific exchange rate. Derivatives that could be used to hedge this kind of risk include currency futures and currency swaps.

A speculator who expects the euro to appreciate compared to the dollar could profit by using a derivative that rises in value with the euro. When using derivatives to speculate on the price movement of an underlying asset, the investor does not need to have a holding or portfolio presence in the underlying asset.

Common Forms of Derivatives

There are many different types of derivatives that can be used for risk management, for speculation, and to leverage a position. Derivatives is a growing marketplace and offer products to fit nearly any need or risk tolerance.

Futures

Futures contracts—also known simply as futures—are an agreement between two parties for the purchase and delivery of an asset at an agreed upon price at a future date. Futures trade on an exchange, and the contracts are standardized. Traders will use a futures contract to hedge their risk or speculate on the price of an underlying asset. The parties involved in the futures transaction are obligated to fulfill a commitment to buy or sell the underlying asset.

For example, say that Nov. 6, 2019, Company-A buys a futures contract for oil at a price of $62.22 per barrel that expires Dec. 19, 2019. The company does this because it needs oil in December and is concerned that the price will rise before the company needs to buy. Buying an oil futures contract hedges the company's risk because the seller on the other side of the contract is obligated to deliver oil to Company-A for $62.22 per barrel once the contract has expired. Assume oil prices rise to $80 per barrel by Dec. 19, 2019. Company-A can accept delivery of the oil from the seller of the futures contract, but if it no longer needs the oil, it can also sell the contract before expiration and keep the profits.

In this example, it is possible that both the futures buyer and seller were hedging risk. Company-A needed oil in the future and wanted to offset the risk that the price may rise in December with a long position in an oil futures contract. The seller could be an oil company that was concerned about falling oil prices and wanted to eliminate that risk by selling or "shorting" a futures contract that fixed the price it would get in December.

It is also possible that the seller or buyer—or both—of the oil futures parties were speculators with the opposite opinion about the direction of December oil. If the parties involved in the futures contract were speculators, it is unlikely that either of them would want to make arrangements for delivery of several barrels of crude oil. Speculators can end their obligation to purchase or deliver the underlying commodity by closing—unwinding—their contract before expiration with an offsetting contract.

For example, the futures contract for West Texas Intermediate (WTI) oil trades on the CME represents 1,000 barrels of oil. If the price of oil rose from $62.22 to $80 per barrel, the trader with the long position—the buyer—in the futures contract would have profited $17,780 [($80 - $62.22) X 1,000 = $17,780]. The trader with the short position—the seller—in the contract would have a loss of $17,780.

Not all futures contracts are settled at expiration by delivering the underlying asset. Many derivatives are cash-settled, which means that the gain or loss in the trade is simply an accounting cash flow to the trader's brokerage account. Futures contracts that are cash settled include many interest rate futures, stock index futures, and more unusual instruments like volatility futures or weather futures.

Forwards

Forward contracts—known simply as forwards—are similar to futures, but do not trade on an exchange, only over-the-counter. When a forward contract is created, the buyer and seller may have customized the terms, size and settlement process for the derivative. As OTC products, forward contracts carry a greater degree of counterparty risk for both buyers and sellers.

Counterparty risks are a kind of credit risk in that the buyer or seller may not be able to live up to the obligations outlined in the contract. If one party of the contract becomes insolvent, the other party may have no recourse and could lose the value of its position. Once created, the parties in a forward contract can offset their position with other counterparties, which can increase the potential for counterparty risks as more traders become involved in the same contract.

Swaps

Swaps are another common type of derivative, often used to exchange one kind of cash flow with another. For example, a trader might use an interest rate swap to switch from a variable interest rate loan to a fixed interest rate loan, or vice versa.

Imagine that Company XYZ has borrowed $1,000,000 and pays a variable rate of interest on the loan that is currently 6%. XYZ may be concerned about rising interest rates that will increase the costs of this loan or encounter a lender that is reluctant to extend more credit while the company has this variable rate risk.

Assume that XYZ creates a swap with Company QRS, which is willing to exchange the payments owed on the variable rate loan for the payments owed on a fixed rate loan of 7%. That means that XYZ will pay 7% to QRS on its $1,000,000 principal, and QRS will pay XYZ 6% interest on the same principal. At the beginning of the swap, XYZ will just pay QRS the 1% difference between the two swap rates.

If interest rates fall so that the variable rate on the original loan is now 5%, Company XYZ will have to pay Company QRS the 2% difference on the loan. If interest rates rise to 8%, then QRS would have to pay XYZ the 1% difference between the two swap rates. Regardless of how interest rates change, the swap has achieved XYZ's original objective of turning a variable rate loan into a fixed rate loan.

Swaps can also be constructed to exchange currency exchange rate risk or the risk of default on a loan or cash flows from other business activities. Swaps related to the cash flows and potential defaults of mortgage bonds are an extremely popular kind of derivative—a bit too popular. In the past. It was the counterparty risk of swaps like this that eventually spiraled into the credit crisis of 2008.

Options

An options contract is similar to a futures contract in that it is an agreement between two parties to buy or sell an asset at a predetermined future date for a specific price. The key difference between options and futures is that, with an option, the buyer is not obliged to exercise their agreement to buy or sell. It is an opportunity only, not an obligation—futures are obligations. As with futures, options may be used to hedge or speculate on the price of the underlying asset.

Imagine an investor owns 100 shares of a stock worth $50 per share they believe the stock's value will rise in the future. However, this investor is concerned about potential risks and decides to hedge their position with an option. The investor could buy a put option that gives them the right to sell 100 shares of the underlying stock for $50 per share—known as the strike price—until a specific day in the future—known as the expiration date.

Assume that the stock falls in value to $40 per share by expiration and the put option buyer decides to exercise their option and sell the stock for the original strike price of $50 per share. If the put option cost the investor $200 to purchase, then they have only lost the cost of the option because the strike price was equal to the price of the stock when they originally bought the put. A strategy like this is called a protective put because it hedges the stock's downside risk.

Alternatively, assume an investor does not own the stock that is currently worth $50 per share. However, they believe that the stock will rise in value over the next month. This investor could buy a call option that gives them the right to buy the stock for $50 before or at expiration. Assume that this call option cost $200 and the stock rose to $60 before expiration. The call buyer can now exercise their option and buy a stock worth $60 per share for the $50 strike price, which is an initial profit of $10 per share. A call option represents 100 shares, so the real profit is $1,000 less the cost of the option—the premium—and any brokerage commission fees.

In both examples, the put and call option sellers are obligated to fulfill their side of the contract if the call or put option buyer chooses to exercise the contract. However, if a stock's price is above the strike price at expiration, the put will be worthless and the seller—the option writer—gets to keep the premium as the option expires. If the stock's price is below the strike price at expiration, the call will be worthless and the call seller will keep the premium. Some options can be exercised before expiration. These are known as American-style options, but their use and early exercise are rare.

Advantages of Derivatives

As the above examples illustrate, derivatives can be a useful tool for businesses and investors alike. They provide a way to lock in prices, hedge against unfavorable movements in rates, and mitigate risks—often for a limited cost. In addition, derivatives can often be purchased on margin—that is, with borrowed funds—which makes them even less expensive.

Downside of Derivatives

On the downside, derivatives are difficult to value because they are based on the price of another asset. The risks for OTC derivatives include counter-party risks that are difficult to predict or value as well. Most derivatives are also sensitive to changes in the amount of time to expiration, the cost of holding the underlying asset, and interest rates. These variables make it difficult to perfectly match the value of a derivative with the underlying asset.

Pros

• Lock in prices

• Hedge against risk

• Can be leveraged

• Diversify portfolio

Cons

• Hard to value

• Subject to counterparty default (if OTC)

• Complex to understand

• Sensitive to supply and demand factors

Also, since the derivative itself has no intrinsic value—its value comes only from the underlying asset—it is vulnerable to market sentiment and market risk. It is possible for supply and demand factors to cause a derivative's price and its liquidity to rise and fall, regardless of what is happening with the price of the underlying asset.

Finally, derivatives are usually leveraged instruments, and using leverage cuts both ways. While it can increase the rate of return it also makes losses mount more quickly.

Real World Example of Derivatives

Many derivative instruments are leveraged. That means a small amount of capital is required to have an interest in a large amount of value in the underlying asset.

For example, an investor who expects the S&P 500 Index to rise in value could buy a futures contract based on that venerable equity index of the largest U.S. publicly traded companies. The notional value of a futures contract on the S&P 500 is $250,000.