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Derivatives :A derivative is a conditional instrument used by market participants to trade or manage an asset. There are essentially two categories of financial instruments that are grouped under the term derivatives: options/futures and swaps.
Options or futures are different kinds of contracts where one party agrees to pay a fee to another for the right to buy or sell something to the other.
For example, a person worried that the price of his Microsoft stock may go down soon just before he plans to sell it may pay a fee to another person who agrees to buy the stock from him at today's price. The person in this example is using an option or future to manage the risk that his stock may go down, while the person he pays a fee to might be using the option as a way to speculate that Microsoft's stock will actually increase, and if so would earn more money then if he were to simply buy Microsoft's stock.
Later, contracts known as swaps appeared, where one party agrees to swap something with another depending on certain circumstances.
For example, one person desiring a fixed rate loan for his business-1, finding that all banks only offer him a variable rate, enters into an agreement with business-2 to have business-2 pay business-1 when rates go up and business-1 must pay business-2 when rates go down, effectively creating a fixed rate for business-1 and possibly saving business-2
money or helping it to convert some of its fixed rate debt into variable rate. Since both of these types of contracts were between two parties, and could be used for risk management or speculation, these contracts became commonly known as "derivatives".
Derivatives can be based on different types of assets such as commodities, equities or bonds, interest rates, exchange rates, or indices (such as a stock market index, consumer price index (CPI) or even an index of weather conditions). Their performance can determine both the amount and the timing of the payoffs.
The main use of derivatives is to either remove risk or take on risk depending if one were a
hedger or a speculator. The diverse range of potential underlying assets and payoff alternatives leads to a huge range of derivatives contracts available to be traded in the market.
The main types of derivatives are futures, forwards, options and swaps. In today's uncertain world, derivatives are increasingly being used to protect assets from drastic fluctuations and at the same time they are being re-engineered to cover all kinds of risk and with this the growth of the derivatives market continues.
Usages
Insurance and hedging : One use of derivatives is as a tool to transfer risk.
For example, farmers can sell futures contracts on a crop to a speculator before the harvest. The farmer offloads (or hedges) the risk that the price will rise or fall, and the speculator accepts the risk with the possibility of a large reward. The farmer knows for certain the revenue he will get for the crop that he will grow; the speculator will make a profit if the rice rises, but also risks making a loss if the price falls.
It is not uncommon for farmers to walk away smiling when they have lost out in the derivatives
market as the result of a hedge. In this case, they have profited from the real market from the sale of their crops. Contrary to popular belief, financial markets are not always a zero-sum game. This is an example of a situation where both parties in a financial markets transaction benefit.
Another example is the company General Electric. This company uses derivatives to "match funding" (GE web cast on derivatives) to mitigate interest rate and currency risk, and to lock in material costs.
The program is strictly for forecasted and highly anticipated needs, and not a means to generate non-operating revenues. 90% of all derivatives revenue produced by derivatives sellers is for this kind of cost, cash, accounts receivable and accounts payable planning. On 2005-06 the company restated earnings with as much as $0.05 quarterly EPS (over 10%) in Q3 2003 (Revised 2004 10K (PDF, 787 KB)).
Speculation and arbitrage : Of course, speculators may trade with other speculators as well as with hedgers. In most financial derivatives markets, the value of speculative trading is far higher than the value of true hedge trading.
As well as outright speculation, derivatives traders may also look for arbitrage opportunities between different derivatives on identical or closely related underlying securities.
Derivatives such as options, futures, or swaps, generally offer the greatest possible reward for betting on whether the price of an underlying asset will go up or down.
For example, a person may believe that a drug company may find a cure for cancer in the next year. If the person bought the stock, for $10.00 and it went to 20.00 after the cure was announced, the person would have made a 100% return.
If he borrowed money to buy the stock (in US law the general maximum he could borrow would be 5.00 or half of the purchase price), he could have bought the stock for 5 dollars and made a 300% return.
However, if he paid a 1 dollar option premium to buy the stock at 11 dollars, when it shot up to 20 dollars he could have received the difference (9 dollars) and thus make a 900% return.
Other uses of derivatives are to gain an economic exposure to an underlying security in situations where direct ownership of the underlying is too costly or is prohibited by legal or regulatory restrictions, or to create a synthetic short position.
In addition to directional plays (i.e. simply betting on the direction of the underlying security),
speculators can use derivatives to place bets on the volatility of the underlying security. This technique is commonly used when speculating with traded options.
Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Lesson, a trader at Barings Bank, made poor and unauthorized investments in index futures. Through a combination of poor judgment on his part, lack of oversight by management, a naive regulatory environment and unfortunate outside events like the Kobe earthquake, Lesson incurred a 1.3 billion dollar loss that bankrupted the centuries old financial institution.
