What are Financial Derivatives and Their Advantages?

What are Financial Derivatives and Their Advantages?

There are three main categories of financial instruments: stocks (equities and shares), debt (mortgages and bonds) and derivatives. In the financial markets, derivatives are contracts, the value of which is derived from an underlying asset. These underlying assets could be a commodity, an index, cash, currencies or interest rates.

Derivatives are important financial instruments that can be hugely beneficial, if used properly. Ancient history shows that derivatives were actually created to solve real-world issues.

A Brief History

The earliest derivative contract can be traced back to 8000 BCE in Sumer, where clay tokens were baked into spherical envelopes. Timeframes were imprinted on the tokens, while the vessel denoted a specific amount of commodity promised to the counterparty. Different types of derivatives continued to evolve throughout the Middle Ages, particularly for commercial trades through sea and land. One party funded a journey, while the counterparty took on the responsibility of bringing back a precious commodity from faraway lands. In the 13th century, the Italian government issued the Monti, which were derivatives with promise to repay debts and raise money for city development purposes.

In the 18th century, feudal Japan resorted to futures contracts for rice trading in the Dojima Rice Exchange in Osaka. Modern derivatives came in during the 1800s, with the formation of the Chicago Board of Trade in USA, to trade dairy, foreign grain and other agricultural products through forwards and futures.

With the introduction of computers in the 1970s, the popularity of derivatives increased across the world. In 1992, trading became electronic, and the derivatives market expanded globally, paving the way for modern derivatives exchanges.

Types of Derivatives

Broadly, there are two types of derivatives. Over-the-counter derivatives are traded privately and exchange-traded derivatives that are traded on specialised exchanges. Although modern derivatives have branched out into variations, such as synthetic collateralised debt obligations (CDO) and credit default swaps (CDS), they can mainly be divided into 4 types:

1.      Forwards

These are the oldest and simplest form of derivatives that exist today. Forwards are contractual agreements between two parties, where a specific date of payment is set in the future, based on today’s spot price or a pre-determined price.

2.      Futures

These are more or less similar to forwards contracts. An asset is bought or sold at a specific date in the future, based on a pre-determined price. But, unlike forwards contracts, futures are standardised agreements, crafted by a clearing house and traded on an exchange. Forwards, in comparison, are flexible.

3.      Options

Here a party has the right, but not the obligation, to buy or sell an asset at a future date (maturity date). The price at which the transaction takes place is set at the time of entering into the contract, also known as the strike price. While European options require transactions to be done only on (and not before) the maturity date, the American variants allow transaction at any time leading to the maturity date.

In case a party decides to assert its right to sell or buy, the counterparty has an obligation to fulfill the terms. Options that are created for purchasing an asset are called call options, while those for selling are put options. A special type of option, called binary options, provides all-or-nothing profit terms.

4.      Swaps

These are contracts that allow the exchange of cash flow between two parties, on or before a specified date in the future. The exchange takes place, based on the underlying asset value, which can be currency exchange rates, interest rates, bonds, stocks, commodities and others.

Advantages of Derivatives

Derivatives are used for a number of reasons, including:

·         Hedging or Mitigating Risk

Since the value of the contract is intrinsically linked to the underlying asset price, it can be used to insure against losses caused by unexpected price drops or hikes. It allows risk related to the price of the underlying asset to be transferred from one party to another. For instance, a miller and wheat farmer sign a futures contract to exchange a particular amount of wheat for a set price in the future. This reduces the price uncertainty of wheat for the farmer, while reducing the risk related to availability of wheat for the miller.

Many businesses borrow large sums of money at a particular interest rate through forward rate agreements, which stabilises earnings and reduces the risk of interest rate hikes in the future.

5.      Determining the Price of Underlying Assets

Derivatives are often used to determine the price of the assets. For example, spot prices of futures contracts give an idea of the approximate price of a commodity.

6.      Speculation and Arbitrage

Derivatives can be used to hedge risk as well as acquire risk. Speculators can buy an asset at a low price in the future, based on a derivatives contract, even when the price rises in the future. They can also sell assets at a high price in the future, when market prices are actually going down. Riskless profits can also be enabled by entering into simultaneous transactions in two or more markets.

7.      Increasing Market Efficiency

A trader can replicate the payoff of the assets using derivatives contracts. Prices of the underlying assets and the contract tend to remain in equilibrium, negating arbitrage opportunities. This helps increase the efficiency of the financial markets.

8.      Access to Different Markets and Assets

Individuals and organisations can gain access to unavailable or otherwise hard-to-trade assets and markets. Companies can borrow money at favourable interest rates, rather than higher rates in the current market.

9.      Tax Benefits

There are derivatives like equity swaps, where an investor can get steady payments based on the LIBOR rate, while avoiding capital gains tax.

Derivatives are an important part of the global financial markets. The gross market value of OTC derivatives alone stood at $10 trillion at the end of June 2018. But they do have counterparty, price and systemic risks associated with them, which are important to consider before entering into any agreement.

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