# Concept of financial derivative:
In
simple, the word “derivative” means “derived or whose value is dependent upon
something”. Derivatives are the financial instruments that are traded in
financial market whose values are derived from underlying assets. The
underlying asset may be commodity, financial asset, interest rate, stock index
and so on. The value of underlying assets depends upon the market conditions
(i.e. micro and macro-economic variables).
The most common underlying assets for derivatives are stocks, bonds, commodities, currencies, interest rates and market indexes . The corporations or government do not issue derivative like securities.
Derivatives are the financial contract between two parties to purchase or sell the underlying asset, a group of assets, or a benchmark, at particular price at particular future date.
Organized
exchange or OTC Market.
· Stock Exchange Market
(for securities listed in national stock exchange (- In Nepal, securities
exchange board of Nepal (SEBON))
#Features/Characteristics of financial derivative:
1. Derivative is a contract (bilateral and not multilateral contract) : Derivatives are the financial contract between two parties to purchase or sell the underlying asset at particular price at particular future date.
2. It has two party i.e. buyer and seller
3. The value of derivative depends upon the value of underlying assets.
Oppositely related payoff (i.e. gain to one party = loss to another party). Gain and loss of payoff from both the party if summed up than it the result is always zero. Therefore, derivatives are also called “zero-sum game”.
4. Right and Obligation: derivatives gives right and obligation to exercise the contract.
Right to
one party and obligation to another or
Right and
obligation to both the parties (buyer and seller)
For e.g.:
· futures, forwards, swap – gives right and obligation to both buyer and seller.
Option contract – gives right to holder or buyer but not obligation to purchase or sell at later date, at a price agreed upon today. However, there is obligation to the option writer / option seller to execute the contract. To get this right, the buyer pays “option Premium” to the option writer or seller.
o Call option gives
buyer the right to buy whereas,
o Put option gives right to sell the option contract.
5 . Agreement for Future: Derivatives are the financial contract between two parties to purchase or sell the underlying asset at particular price at particular future date at a price agreed upon today
6. Means of Management of Risk:
As we know, higher risk higher the profits. Risk arises
due to changes in micro and macro-economic variables. Derivatives instruments are used as a means
to manage risk through:
·
Hedging (reducing risk),
·
Speculating (bear extra risk) and
· Arbitrage (gain from price advantage from two market).
# Types
of financial derivative:
Assets can be of two types: financial assets and real assets
Financial assets can be of two types: primary financial assets (common stock, preference stock, bond, debentures) and derived financial assets also known as derivatives.
Derivatives can be of following types:
- 1. Options (call or put)
- 2. Futures
- 3. Forwards
- 4. Swap
- 5. Warrant
- 6. Others- options on futures, swaption (option on swap),
hybrids (having mix of features of different derivatives)
# Uses /
Applications of financial derivative:
The uses
or application of financial derivatives are as follows:
- 1
Lock in prices (prices of future are locked today)
- 2 Hedge against risk (protection against minimum price risk) :
Hedging is a risk management strategy employed to offset
(protect against) losses in investments by taking an opposite position in a
related asset. Hedging requires one to pay money for the protection it
provides, known as the premium. Investors hedge one investment by making a
trade in another. Like: insurance but something vague.
Eg.
If we
have a lot of shares of NIFRA and worried of prices down, you can sell futures of
NIFRA to hedge the risk. If this materializes, the value of stock will go down
but the value of hedge (short position) will go high. So, this hedge will
protect you against huge loss.
Or , You
can buy options – put option same case, the value of stock will go down but value
of put option goes high, giving some relief against losses.
MNCs uses foreign currency options and currency swaps are
used to hedge against currency risk
Interest rate swap and interest rate forwards are used to
hedge against interest rate risk.
Under hedging activities, gain on investment counterbalances the loss on another.
An individual who enters into hedging trades are called hedgers.
- 3
Providing leverage
facilities (derivatives are contracts and requires a
small amount of margin, these assets provides high leverage. So, there is
possibility of getting high profit with small investment.)
- 4 Providing Arbitrage
facilities:
Arbitrage is trading that involves buying a product and
selling it immediately in another market for a higher price; thus, making small
but steady profits. Hence, derivatives are used to capture the profit
from disequilibrium (i.e difference between over and underpricing of
derivatives).
For e.g. The stock of Company X is trading at $20 on the
New York Stock Exchange (NYSE), while, at the same moment, it is trading for
$20.05 on the London Stock Exchange (LSE). A trader can buy the stock on the
NYSE and immediately sell the
same shares on the LSE, earning a profit of 5 cents per share.)
- 5 Portfolio
diversification (there is a famous saying “don’t put all
your eggs in a single basket”. A portfolio is a collection of financial
investments. Diversification tries to reduce risk by allocating investments among various financial
instruments, industries, and other categories. Derivatives helps to diversify
the risk associated with investment (mix of long term and short term
investments, mix of derivatives (options, swap, futures, forwards) in various
commodity instruments.
- 6 Speculation and
generating profits (speculation is focused on short-term trading and profiting from
market fluctuations.)
- 7
Change the nature of
investment (or liabilities): Derivative
instruments provides means to change the nature of investment (or liabilities).
For e.g. Floating rate investment (or liabilities) can be converted into fixed
rate investments (or liabilities) and vice versa.
- 8
Creating new /hybrid
securities: The process of creating new securities is
called financial engineering. Using derivatives, traders can change --the
level of risk, return, swap with options, combination of different derivative
feature with derivative instrument and therefore, create an innovative
instrument.
#Participants of financial derivative:
The participants in the derivatives market can be broadly categorized into the following groups:
- · Dealers: They are
called market makers. Dealers are the financial institutions or firms ready to
take risk from buy/sell of securities on their accounts.
- · Brokers: They are
intermediaries. They are the agents who facilitates to buy/sell securities for
investors by charging brokerage commission. They do not take the risk to buy on
their account.
- ·
Hedgers: An individual who enters
into hedging trades are called hedgers.
Hedging is a risk management strategy employed to offset (protect against)
losses in investments by taking an opposite position in a related asset.
Hedging requires one to pay money for the protection it provides, known as the
premium. Under hedging activities,
gain on investment counterbalances the loss on another.
- · Speculators: they are
the one who engages in speculative transactions. Speculators can gain profit
from both up and down trend of the market. Speculation is focused on short-term trading and profiting from
market fluctuations.
- Arbitrageurs: an individual engaged in arbitrage is called arbitrageurs. Arbitrage is trading that involves buying a product and selling it immediately in another market for a higher price; thus, making small but steady profits. Hence, derivatives are used to capture the profit from disequilibrium (i.e difference between over and underpricing of derivatives).
- · Margin traders: Margin
traders are individuals or entities who engage in margin trading. Margin
trading is a financial strategy where traders borrow funds from a broker or
exchange to increase their buying power beyond their available capital. By
leveraging these borrowed funds, traders can control larger positions in the
market than they could with their own money alone.
# Function of financial derivative:
The major
functions of derivatives markets in an economy include:
- 1. Risk Management:
One of
the primary functions of derivatives markets is to effectively manage risks.
Businesses face multiple risks in day-to-day operations, including currency
fluctuations, interest rate changes, and commodity price volatility. Derivative
contracts help companies hedge against these risks, drive profitability and
ensure stable operations.
- 2. Price Discovery
Derivatives
offer a platform for traders and investors to express their views on future
asset prices. These price signals are critical for investors, as they help
assess market sentiment and make informed investment decisions. They also
enable efficient allocation of resources by providing real-time insights about
market expectations.
- 3. Liquidity Enhancement
Derivatives
markets significantly enhance market liquidity - the ease with which an asset
can be bought or sold without causing a sharp rise/decline in prices. This
liquidity benefits both hedgers and speculators. Hedgers can easily find
counterparties to take the other side of their trades, while speculators can
execute their strategies efficiently.
- 4. Providing leverage facilities:
Derivatives
are contracts and requires a small amount of margin, these assets provide high
leverage. So, there is possibility of getting high profit with small
investment.
- 5. Providing Arbitrage facilities:
Arbitrage is trading that involves buying a
product and selling it immediately in another market for a higher price; thus,
making small but steady profits. Hence, derivatives are used to capture
the profit from disequilibrium (i.e difference between over and underpricing of
derivatives).
For e.g. The stock of Company X is trading at
$20 on the New York Stock Exchange (NYSE), while, at the same moment, it is
trading for $20.05 on the London Stock Exchange (LSE). A trader can buy the
stock on the NYSE and immediately sell the same shares on the LSE, earning a profit of 5
cents per share.)
- 6. Low transaction cost:
Derivative
act as risk management tool, the cost of trading in derivatives is low.
- 7. Risk Transfer:
Derivatives
markets facilitate risk transfer from those who are less capable of
withstanding risk to those who are more risk-tolerant. For instance, an
insurance company may use derivatives to transfer the risk of catastrophic
events, such as natural disasters or financial market crashes to the broader financial
market. This risk transfer mechanism helps mitigate systemic risk, distributing
it among a broader pool of market participants.
- 8. Speculation and generating profits : Speculation is focused on short-term trading and profiting from
market fluctuations. Therefore, speculation and generation of profit is the
function of derivatives.
# Danger of financial derivative: # Disadvantages of
Derivatives:
The
derivatives market also comes attached with a set of its own disadvantages.
Following are the drawbacks of the derivative market:
- ·
High Leverage Risks
Due to
the leveraged nature of financial derivatives, even small price movements in
the underlying asset can result in substantial financial losses.
- ·
Overpriced Options
(Hard to value)
The
derivatives are not easy to value as they are derived from other securities.
Besides, the derivatives market is not as liquid as the stock market and there
are not many “players” as well. Hence, there is much larger bidding which
results in price increment.
- ·
Time Restrictions
The prime
reason for the derivatives market to be risky for the investors is that they
have a specified contract life. After their life expires, the contract becomes
of no use.
- ·
Complexity and Lack
of transparency
Most
people are not aware about the complexity of the derivatives market. Hence, it
fosters the scam actors to utilize this weakness and use the derivatives to
take advantage by the investors. The lack
of transparency in the market for derivatives can create uncertainties and
increase risks for participants.
- ·
Legalized Gambling
Due to
the nature of trading in financial markets, derivatives are criticized for
being a type of legalized form of gambling as it is very much similar to the
other types of gambling activities.
- ·
Counterparty risks
(if OTC):
Derivatives
trading also entails counterparty risk, which refers to the risk of default by
the other party involved in a derivative contract. In over-the-counter (OTC) derivatives,
where contracts are privately negotiated, there is a reliance on the financial
strength and integrity of the counterparty. Counterparty risk can be mitigated
using central clearinghouses or exchanges, but it remains a potential downside
of derivatives trading.
In
conclusion, are derivatives really at fault? Is electricity to be faulted if
someone with little knowledge mishandles it? So, using derivatives in
inappropriate situation is dangerous.
#Myths / controversies about Financial Derivatives:
Derivatives
may be differently perceived by different people and can be misinterpreted that
may not stand to be true. An economist and policy advisor, Thomas F.Siems
, authored a paper published by Cato Institute in September 1997 entitled
“10 Myths About Financial Derivatives” .
Considering the views of an economist Thomas F.Siems, following are the myths and realities of financial derivatives
- Derivatives are new and complex
- Derivatives are high Tec financial products created by Wall Streets rocket scientist
- Derivatives are purely speculative
- Derivatives are highly leveraged instruments
- Only large multinational corporations and large banks have purpose of using derivatives
- Financial derivatives takes money out of productive process
- Only risk seeking organization should use derivatives
- The risk associated with financial derivatives are new and unknown.
- Derivatives are latest risk management fad
- The large (enormous) size of the financial derivatives markets dwarfs bank capital (i.e. make the banks’ capital small), making it an unsafe and unsound banking practices.
Pic Credit:https://prillionaires.com
