Stepping forward, looking to the future

The Oxford Dictionary defines derivatives as a financial product (such as a future, option, or warrant) whose value is derived from and is dependent on the value of an underlying asset. This underlying asset can be Nifty 50 stock index, temperature at New York's LaGuardia Airport or the number of bankruptcies among a group of selected companies. Some estimate this market to exceed $700 trillion in size.

Derivatives have gained notoriety due to their association with few notable events such as the collapses of Barings Bank and Long-Term Capital Management. The later was a hedge fund whose partners included an economist with a Nobel Prize awarded for breakthrough research in pricing derivatives. Derivatives even had a role in the fall of Enron. Indeed, Warren Buffett concluded that “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

But instead of arguing whether derivatives are good or bad, we will discuss about the various aspects of the derivative market through this column.

So why were derivatives created? The main intention behind creating derivatives was to better manage risks. But of course they exemplify risks if not regulated properly, like the recent sub-prime crisis. Investors can utilise derivatives for the following purposes,

Hedging: Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another. For instance, an oil refiner could sign a contract to exchange oil for a specified amount of cash with an oil producer. This way the refiner is hedged for the risk associated with the increase in price of the oil in the future and oil producer is hedged for the risk associated with the fall in the price of the oil in future. However, there is a risk that one party might renege on the contract. Although a third party, called a clearing house, insures the contract, not all derivatives are insured against counterparty risk.

Derivatives are used to provide leverage, such that a small movement in the underlying value can cause a large difference in the value of the derivative. This allows investors to take an exposure that is many times their capital outlay. They can also hedge greater amount with less funds.

Speculation: Speculators can sell a derivative contract if they expect the price to move lower in future. Similarly, they can buy the contract if they expect the underlying price to increase. This can be done without the hassle of taking delivery of the underlying or having to deliver the asset sold.

Obtain exposure to the underlying where it is not possible to trade in the underlying such as weather derivatives.

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