practice, this characteristic will be retained as an implied, albeit critical, factor distinguishing derivatives from mutual funds and exchange-traded funds and some other straight pass-through instruments. Also, note that the idea that derivatives take their performance from an underlying asset encompasses the fact that derivatives take their value and certain other characteristics from the underlying asset. Derivatives strategies perform in ways that are derived from the underlying and the specific features of derivatives.
Derivatives are similar to insurance in that both allow for the transfer of risk from one party to another. As everyone knows, insurance is a financial contract that provides protection against loss. The party bearing the risk purchases an insurance policy, which transfers the risk to the other party, the insurer, for a specified period of time. The risk itself does not change, but the party bearing it does. Derivatives allow for this same type of transfer of risk. One type of derivative in particular, the put option, when combined with a position exposed to the risk, functions almost exactly like insurance, but all derivatives can be used to protect against loss. Of course, an insurance contract must specify the underlying risk, such as property, health, or life. Likewise, so do derivatives. As noted earlier, derivatives are associated with an underlying asset. As such, the so-called “underlying asset” is often simply referred to as the underlying, whose value is the source of risk.1 In fact, the underlying need not even be an asset itself. Although common derivatives underlyings are equities, fixed-income securities, currencies, and commodities, other derivatives underlyings include interest rates, credit, energy, weather, and even other derivatives, all of which are not generally thought of as assets. Thus, like insurance, derivatives pay off on the basis of a source of risk, which is often, but not always, the value of an underlying asset. And like insurance, derivatives have a definite life span and expire on a specified date.
Derivatives are created in the form of legal contracts. They involve two parties – the buyer and the seller (sometimes known as the writer) – each of whom agrees to do something for the other, either now or later. The buyer, who purchases the derivative, is referred to as the long or the holder because he owns (holds) the derivative and holds a long position. The seller is referred to as the short because he holds a short position.2
A derivative contract always defines the rights and obligations of each party. These contracts are intended to be, and almost always are, recognized by the legal system as commercial contracts that each party expects to be upheld and supported in the legal system. Nonetheless, disputes sometimes arise, and lawyers, judges, and juries may be required to step in and resolve the matter.
There are two general classes of derivatives. Some provide the ability to lock in a price at which one might buy or sell the underlying. Because they force the two parties to transact in the future at a previously agreed-on price, these instruments are called forward commitments. The various types of forward commitments are called forward contracts, futures contracts, and swaps. Another class of derivatives provides the right but not the obligation to buy or sell the underlying at a pre-determined price. Because the choice of buying or selling versus doing nothing depends on a particular random outcome, these derivatives are called contingent claims. The primary contingent claim is called an option. The types of derivatives will be covered in more detail later in this reading and in considerably more depth later in the curriculum.
The existence of derivatives begs the obvious question of what purpose they serve. If one can participate in the success of a company by holding its equity, what reason can possibly explain why another instrument is required that takes its value from the performance of the equity? Although equity and other fundamental markets exist and usually perform reasonably well without derivative markets, it is possible that derivative markets can improve the performance of the markets for the underlyings. As you will see later in this reading, that is indeed true in practice.
Derivative markets create beneficial opportunities that do not exist in their absence. Derivatives can be used to create strategies that cannot be implemented with the underlyings alone. For example, derivatives make it easier to go short, thereby benefiting from a decline in the value of the underlying. In addition, derivatives, in and of themselves, are characterized by a relatively high degree of leverage, meaning that participants in derivatives transactions usually have to invest only a small amount of their own capital relative to the value of the underlying. As such, small movements in the underlying can lead to fairly large movements in the amount of money made or lost on the derivative. Derivatives generally trade at lower transaction costs than comparable spot market transactions, are often more liquid than their underlyings, and offer a simple, effective, and low-cost way to transfer risk. For example, a shareholder of a company can reduce or even completely eliminate the market exposure by trading a derivative on the equity. Holders of fixed-income securities can use derivatives to reduce or completely eliminate interest rate risk, allowing them to focus on the credit risk. Alternatively, holders of fixed-income securities can reduce or eliminate the credit risk, focusing more on the interest rate risk. Derivatives permit such adjustments easily and quickly. These features of derivatives are covered in more detail later in this reading.
The types of performance transformations facilitated by derivatives allow market participants to practice more effective risk management. Indeed, the entire field of derivatives, which at one time was focused mostly on the instruments themselves, is now more concerned with the uses of the instruments. Just as a carpenter uses a hammer, nails, screws, a screwdriver, and a saw to build something useful or beautiful, a financial expert uses derivatives to manage risk. And just as it is critically important that a carpenter understands how to use these tools, an investment practitioner must understand how to properly use derivatives. In the case of the carpenter, the result is building something useful; in the case of the financial expert, the result is managing financial risk. Thus, like tools, derivatives serve a valuable purpose but like tools, they must be used carefully.
The practice of risk management has taken a prominent role in financial markets. Indeed, whenever companies announce large losses from trading, lending, or operations, stories abound about how poorly these companies managed risk. Such stories are great attention grabbers and a real boon for the media, but they often miss the point that risk management does not guarantee that large losses will not occur. Rather, risk management is the process by which an organization or individual defines the level of risk it wishes to take, measures the level of risk it is taking, and adjusts the latter to equal the former. Risk management never offers a guarantee that large losses will not occur, and it does not eliminate the possibility of total failure. To do so would typically require that the amount of risk taken be so small that the organization would be effectively constrained from pursuing its primary objectives. Risk taking is inherent in all forms of economic activity and life in general. The possibility of failure is never eliminated.
EXAMPLE 1 Characteristics of Derivatives
1. Which of the following is the best example of a derivative?
A. A global equity mutual fund
B. A non-callable government bond
C. A contract to purchase Apple Computer at a fixed price
2. Which of the following is not a characteristic of a derivative?
A. An underlying
B. A low degree of leverage
C. Two parties – a buyer and a seller
3. Which of the following statements about derivatives is not true?
A. They are created in the spot market.
B. They are used in the practice of risk management.
C.
Unfortunately, English financial language often evolves without regard to the rules of proper usage.
In the financial world, the
