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A Student’s Guide to Derivatives

Derivatives form part of the world of structured finance, a sphere of the modern financial system that is often considered to be confusing to outsiders. This guide to derivatives aims to provide a brief outline of some of the main types of derivatives and how they are used in the global economy.

So, What is a derivative?

In brief, a derivative is a financial instrument the value of which is derived from another asset, liability or external factor. As the value of the underlying item changes, so does the value of the derivative. In legal terms, derivatives are contracts, pursuant to which parties thereto incur certain rights and obligations.

Derivatives have existed in some form for millennia, but the use of these products exploded in the late 20th century from the 1970s onwards. At the end of June 2016, the notional outstanding amount under over-the-counter derivatives contracts stood at an estimated $544 trillion.

Uses of Derivatives

There are two main uses of derivatives: hedging and speculation.

Hedging

Hedging is used to mitigate a risk such as a change to interest or foreign exchange rates, or in the price of an asset, such as a share in a company or a barrel of oil. To mitigate against an adverse movement in rates or prices, a company may wish to take out a hedging position that is intended to act as insurance in the event that the unwanted variation occurs.

By taking out a position that will produce a profit in the event that an adverse event occurs, the hedging party hopes to mitigate the extent of the losses produced by the unwanted movement.

Speculation

Alternatively, the counterparty to the contract may be entering into the arrangement for the purposes of speculation, seeking to profit from the risk. Derivatives enable speculators to make a profit (and expose the speculator to an equivalent potential loss) from an underlying market, without holding an actual position in the market itself.

Type of Derivatives

A distinction can be drawn between exchange traded derivatives and over-the-counter (“OTC”) derivatives. Exchange traded derivatives come on standardised terms and are traded on exchanges such as the London Metal Exchange and the Intercontinental Exchange. These instruments are often referred to as ‘vanilla’ derivatives. OTC derivatives, however, are bespoke, ‘exotic’ derivatives that are negotiated between the counterparties to the contract. These exotic derivatives are not traded on a central exchange and are only available ‘over-the-counter’ from entities that are capable of offering more complex contracts.

Exchange-Traded Derivatives

Futures

A future is a derivative pursuant to which the parties will agree to buy or sell an asset at a specified time in future for a specified price. These contracts are standardised and are traded on an exchange.

For example, a petrochemicals company, Oil Refining plc may agree to buy crude oil from Oil Corp. at an agreed price of $50 per barrel in 3 months’ time. This has the benefit of securing a guaranteed price for both buyer and seller, protecting against volatility in the price of the underlying asset. The disadvantage for the buyer is that if the price of the asset falls below the price specified in the contract, the buyer is obliged to acquire the asset at the higher price than the current market rate. For the seller, if the price rises above this specified price, it cannot take advantage of this increase and sell at the higher price, resulting in missed profits.

Options

An option functions in a similar manner to a future, in that parties agree to sell (‘put’) or buy (‘call’) an asset at a specified price at a specified time in future. The difference between options and futures, however, is that the derivative contract grants the holder a right to buy or sell the asset, rather than an obligation to do so.

Varying the example above, Oil Refining plc takes out an option to purchase of a number of barrels of oil. If the oil price falls below $50 a barrel at the date falling 3 months from the date of the contract, Oil Refining plc will not exercise its option, instead purchasing it at the market rate. If the option is exercised by Oil Refining plc due to an increase in the price above $50, Oil Corp. will be bound, however, to sell at the agreed price.

Over-the-counter derivatives

Forwards

Forwards are similar to futures in that parties can agree to buy or sell an asset in future at a price that is agreed in advance. However, forwards contracts are not traded on an exchange and are bespoke contracts customised to the needs of the parties involved. Therefore unlike in a futures contract, where the amount of the asset to be delivered and the time for delivery are fixed, a forward may contain a more niche asset, with considerations of the amount to be delivered and the time for delivery being the subject of negotiation. Given the bespoke nature of forwards, and the negotiation involved in agreeing their form, forwards occur ‘over-the-counter’ and are not traded on exchanges.

Swaps

A completely different type of derivative to those set out above is the swap. Swaps involve of the exchange of an obligation. For example, a borrower could swap a fixed interest rate for a floating rate of interest, currency on a loan or exposure to a risk.

Cross-currency swaps allow companies in different locations to obtain cheaper financing. ABC plc, a UK-based supermarket, is seeking to expand its operations in the US. XYZ Inc., a US-based car manufacturer, wants to expand its operations in the UK. Both entities are seeking to raise the money for expansion through bond issuances.

However, it would likely be more expensive for each entity to borrow in a currency other than that of its country of origin. As such, both entities raise funds in their ‘home’ currency, whereby ABC plc issues bonds denominated in Sterling and XYZ Inc. issues bonds denominated in US Dollars. The two entities then enter into a swap contract, pursuant to which the principal is exchanged. Throughout the period of the swap, ABC plc would pay interest to XYZ Inc. in US Dollars and XYZ Inc. would pay interest to ABC plc in Sterling.

Another type of swap, the credit default swap, was the subject of a large amount of criticism following the Global Financial Crisis, largely due to their alleged misuse by certain entities in the years preceding the crisis. A credit default swap allows entities to hedge against the credit risk of another entity, or to speculate on that credit risk.

Investments LLP purchases bonds issued by ABC plc as described above. In doing so, it is exposed to credit risk in that ABC plc may not be able to make its interest payments on the bonds. As such, Investments plc takes out a credit default swap with a hedge fund, Profit LP, paying a premium to Profit LP for providing the swap. Two years into the life of the bond, ABC plc defaults on an interest payment. Rather than the £2,000 interest payment due, ABC plc actually pays out £1,800. Under the credit default swap, Profit LP pays out £200 to Investments plc.

In this example, Investments LLP has used the swap to hedge against credit risk, whereas Profit LP has used the swap to speculate by in essence betting that ABC plc would not default on its interest payments. This provides insurance to Investments LLP with regards to exposure to ABC plc, but in turn exposes it to an additional risk. This is the ‘counterparty risk’ in that the paying party, Profit LP, may not be able pay the amount due under the swap. This risk is amplified if Profit LP fails to ‘net out’ its position by taking out a credit default swap itself on its exposure to ABC plc.

A Guide to Derivatives: Conclusion

Hopefully this guide has provided a useful overview of some of the main types of derivative and how they are used. A full overview of the sphere of derivatives is not possible within the limits of a blog post, but there are many useful resources available on the internet if you are interested in learning more about derivatives.

Sites such as Investopedia contain useful explanations on how derivatives are used, and resources such as the Financial Times and the Economist regularly feature updates on developments in the sphere of derivatives.

by Adam Quigley, Trainee

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