Lesson 14: Financial Derivatives

L13.1 Chart

Image courtesy of investspec.com

Up to this point the assets discussed have been “real” assets.  Said differently the assets (stocks, bonds, commodities) had some level of intrinsic value because they represented some sort of claim either to ownership of a business (stock), debt to be repaid (bond), or some physical good (commodity). There are other assets that have value because they represent a claim to these “real” assets. These assets are known as financial derivatives and are some of the more interesting and colorful financial instruments.

Key Points

  • A financial derivative is a security whose price is determined or derived from the price of the underlying asset.
  • Common types of financial derivatives include options, swaps, futures, and forwards.
  • Financial derivatives are traded either on exchanges or in over-the-counter (OTC) markets.
  • The role of financial derivatives in the market is to help mitigate risk from entities who do not wish to bear risk to entities better suited to manage that risk.

What is a Financial Derivative?

Financial derivatives are a type of financial security whose price is derived from the price of the underlying asset it represents. As opposed to “real assets” whose value comes from the perceived increase in value or the cash flows generated by the real asset, a derivative represents some sort of claim on the real asset. By existing independently of the real asset, the derivative can be traded separately while its value is largely related to the value of the underlying asset.

A Story of Opals and Options

Behold the opulent opal. Image courtesy of stephen-universe.wikia

Let’s assume I, a rare gem seller, have a rare opal (a physical asset) for $1,000.  You want to purchase the gem but are concerned that you may not be able to sell the gem at a higher price and thus will not profit off of the transaction.

Along comes a man who doesn’t know whether the gem is worth more or less but thinks it is worth less than you bought it for. Let’s call him the Pessimistic Guy.  The Pessimistic Guy is willing to sell you a piece of paper saying that he will buy the gem for $800 despite what it’s true price is.  The cost of this piece of paper is $100.

The paper in this situation is commonly referred to as an option as it gives you the option (but not obligation) to sell the underlying physical asset.

So what are the possible outcomes in this scenario?

There are quite a few depending on whether you buy the option and whether the gem is worth more or less than the price you purchased it for as seen by the table below.

Opal table

One of the most notable trends in the table is that if the option is purchased the most you can lose is the difference between the agreed upon purchase price ($800) and the
original  purchase price ($1,000) minus the additional cost of the option ($100).

In this case having bought the option the most you can lose is $800 – $1,000 – $100 = -$300

Though a simple example this reveals one of the main uses of derivatives. In the situation where you bought the option there was an absolute limited loss. The concept of unlimited/limited loss will be discussed in the future as it is both key to understanding the role of derivatives and is a fascinating concept.

What are the Common Types of Financial Derivatives?

There are four primary types of financial derivatives. Though only briefly discussed here, each will receive a more in depth analysis in future lessons.

1.Options: As seen in the example an option is a type of contract that enables the holder to exercise an option (usually buy or sell) on an asset. In the example above you purchased a put option. A put option enables you to sell an asset (the opal) at an agreed upon price ($8) before a predetermined maturity date. In the example we did not set a maturity date for the sake of simplicity. The opposite of a put option is called a call option as it enables you to buy an option at an agreed upon price.

2. Swaps: A swap is a type of financial derivative in which two entities exchange some sort of financial good or instrument.  Though it may seem like commodities may commonly be used in these swaps the most common instrument involved in financial swaps is interest rates.  An interest rate swap is a derivative in which two entities exchange cash flows in order to guard interest rate risk or to participate in speculative finance.

3. Forwards: A forward is a contract in which two entities agree to buy/sell an asset at an agreed upon price at a future date.  Forwards are commonly thought of as the simplest of the derivatives, though with modification can become complex. Forwards are commonly used in the commodity market and are used to hedge against price fluctuations.  For example I could agree to buy 1,000 bushels of wheat in three months for $50/bushel regardless of the market price of a bushel of wheat at that time.

4. Futures: A future is a highly standardized contract in which two entities agree to buy/sell an asset at an agreed upon price at a future date. A future may seem very similar to a forward. It is! A future is simply a highly standardized forward that is traded on an exchange instead of an OTC market (as forwards are).  The purpose of futures is to eliminate a risk known as counterparty risk that is present in forward contracts.  This will be addressed in more detail but for now just know that with more standardization comes the ability for a future to eliminate a type of risk that forwards inherently possess.

How are Financial Derivatives Traded?

Like stocks and bonds financial derivatives trade on both exchanges and over-the-counter (OTC) markets.  The OTC is the larger of the two for trades involving derivatives because of its looser regulatory standards.  Derivatives traded on exchanges (mainly futures) are predetermined and standardized to eliminate counterparty risk. Counterparty risk is the risk that the opposing entity in an agreement will be unable to fulfill its contractual obligation.  This risk is present in OTC contracts as the agreements are private agreements and lack an intermediary that can ensure the fulfillment of the contract.

Why Do Financial Derivatives Exist?

These very interesting and colorful financial instruments exist to satisfy one of the most important goals of finance, to minimize risk.  Through different arrangements an entity (business,person, bank, etc.) is able to essentially sell off some of its risk to some other entity that desires that specific risk.  This may seem abstract now but after some concrete examples in the next few lessons it will make sense why some entities benefit from the use of derivatives and why they have a place in the financial world.

Should I Invest in Financial Derivatives?

TwoPennies

These guys are back with advice.

Here’s the area where I throw in my $0.02 into the ring.

I DO NOT recommend most derivative trading for the average everyday investor.

The reasoning is very simple. Most individuals do not have the time or expertise to understand and dissect these at times incredibly esoteric investment vehicles. That being said there are a few derivatives that do make sense in some instances (a covered call option strategy is an example of one) in which a simple derivative can help minimize and hedge against risk. These instances will be covered in a later lesson.

Definitions

  1. Financial derivative: A type of financial security whose price is derived from the price of the underlying asset it represents
  2. Options: A type of financial derivative that enables the holder to exercise an option (usually buy or sell) on an asset
  3. Swaps: A type of financial derivative in which two entities exchange some sort of financial good or instrument
  4. Forward: A forward is a type of financial derivative in which two entities agree to buy/sell an asset at an agreed upon price at a future date
  5. Future: A type of financial derivative in which two entities exchange some sort of financial good or instrument
  6. Counterparty risk: The risk that the opposing entity in an agreement will be unable to fulfill its contractual obligation

Further Reading

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