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An Overview of Derivatives

By Jamie Johnson

What are derivatives?

Derivatives are financial contracts that get their value from how the entity it is tied to performs financially. The entity in question could be an asset, index or interest rate and is referred to as the “underlying”.

The oldest derivatives were for commodities. Traders could create a contract that would allow them to pay a pre-agreed cost for a particular commodity in order to reduce their risk and plan their company more efficiently. For instance, someone might purchase a derivative in wheat for an amount of $X. If the wheat harvest that year is terrible, the price of wheat generally might go up. However, the person is protected from that because they only have to pay the pre-specified price.

What are the types of derivatives?

There are three types of derivatives: forwards, options and swaps.

Forwards, also known as futures, are contracts that require the buyer and seller to exchange the underlying at the pre-specified price for that underlying. This price applies regardless of the current market price for the underlying. The contract will specify the time that it expires.

Options are similar to futures with a significant difference. Under the contract, the buyer or seller can choose not to buy the underlying at the time of expiry if they do not want to. There are two sub-types of options: call options and put options. Call options allow the buyer to purchase the underlying at a specific price within a designated period. Put options allow the seller to sell the underlying at a specific price within a designated period.

Swaps are where the two parties agree to swap particular financial products or payments for a specified period. There are three prominent examples of these agreements: interest rate swaps, currency swaps and commodity swaps. Interest rates swaps are where two parties swap a loan that has a fixed-rate of interest with a loan that has a floating rate. A currency swap is where two parties swap loan payments in different currencies. So, each party would be repaying a loan in a different currency to the initial currency they took the loan out with. A commodity swap is where two parties swap the cash flows that come from the underlying.

Why would someone use a derivative?

There are three advantages to using a derivative: it hedges risk, it provides someone with access to a new set of markets, and it diversifies an asset portfolio.

Derivatives allow for the hedging of risk because it provides a buffer against the sudden rise or fall in the price of an underlying.

Derivatives also create new markets that might not otherwise exist. Traders can trade assets that might otherwise not be tradable because they can create contracts amongst each other.

Derivatives also diversify asset portfolios because they ensure that traders are exposed to different underlyings than they otherwise would be. This is particularly important for actors like hedge funds who are under pressure from their clients not to lose money.

What are the risks of using a derivative?

There are three disadvantages of using a derivative: they can be hard to value, they have the risk of counter-party default, and the instruments are complicated.

Derivatives can be hard to value because, by their nature, they involve speculation about the value of an underlying. This means that individuals might enter into derivative contracts that do not reflect the value of the underlying at all.

Derivatives can also have the risk of counter-party default if they are traded over the counter. A counter-party default is where the other actor defaults on their obligations. So, for instance, someone might default on their obligation to pay for an underlying under a future.

The complexity of derivatives can mean that traders enter into contracts that they do not fully understand. This is a problem because it means that traders might enter into unfavourable contracts. Additionally, smaller actors might struggle to interact with the derivatives market at all due to its complex nature.

Relevant regulations

There are three main bodies of regulation to be aware of: the Markets in Financial Instruments Directive II (MiFID II), the Markets in Financial Instruments Regulation (MiFIR) and the European Market Infrastructure Regulation (EMIR).

MiFID II and MiFIR together update the regulations from the original MiFID. Across MiFID II and MiFIR, there are three features to be aware of. Firstly, they require derivatives to be standardised and traded in regulated markets. Secondly, they require a greater degree of transparency over the trading of derivatives. For instance, the prices of equity derivatives need to be public. Thirdly, they provide regulators with a greater degree of oversight over commodity derivative markets. Regulators can ask for information about a derivative contract, for example.

Read more about the MiFID II requirements here.

The EMIR is an attempt to stabilise over the counter derivative contracts by reducing the risk of counter-party default. EMIR imposes an obligation for the two actors to clear their trade. They also require firms to mitigate the risks involved in trading these derivatives.

Case studies

SoftBank buys equity derivatives – (September 2020) in September SoftBank revealed that it had bought up billions of US equity derivatives. The derivatives in question were call options, which allow SoftBank to buy stocks in tech companies at pre-agreed prices. This aggressive strategy was said to have driven some of the strong performances in equity for tech firms across the pandemic.

JP Morgan lost $951 million because of derivatives – (April 2020) JP Morgan reported that it made a $951 million loss because of the way that it funded its derivatives. This was because of the poor performance of equity markets at the time, as this was at the beginning of the market volatility caused by the pandemic.

Morgan Stanley loses money because of Lira volatility – (December 2019) the bank announced that it increased its use of foreign-exchange market options after 2016. This was initially extremely lucrative for the bank. However, it left itself exposed to the Turkish Lira. This was a problem because of the volatility of the Turkish Lira in 2019.

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