Derivatives
Derivatives play an important and useful role in the economy, but they also pose several dangers to the stability of financial markets and the overall economy. Derivatives are often employed for the useful purpose of hedging and risk management, and this role becomes more important as financial markets grow more volatile. Derivatives are also used to commit fraud and to manipulate markets.
Derivatives are powerful tools that can be used to hedge the risks normally associated with production, commerce and finance. Derivatives facilitate risk management by allowing a person to reduce his exposure to certain kinds of risk by transferring those risks to another person that is more willing and able to bear such risks.
Today, derivatives are traded in most parts of the world, and the size of these markets is enormous. Data for 2002 by the Bank of International Settlements puts the amount of outstanding derivatives in excess of $151 trillion and the trading volume on organized derivatives exchanges at $694 trillion. By comparison, the IMF’s figure for worldwide output, or GDP, is $32.1 trillion.
A derivative is a financial contract whose value is linked to the price of an underlying commodity, asset, rate, index or the occurrence or magnitude of an event. The term derivative refers to how the price of these contracts is derived from the price the underlying item. Typical examples of derivatives include futures, forwards, swaps and options, and these can be combined with traditional securities and loans in order to create structured securities which are also known as hybrid instruments.
Forward deals are a form of insurance against the risk that exchange rates will change between now and the delivery date of the contract. A forward is a simple kind of a derivative - a financial instrument whose price is based on another underlying asset. The price in a forward contract is known as the delivery price and allows the investor to lock in the current exchange rate and thus avoid subsequent forex fluctuations.
Futures contracts are like forwards, except that they are highly standardized. The futures contracts traded on most organized exchanges are so standardized that they are fungible - meaning that they are substitutable one for another. This fungibility facilitates trading and results in greater trading volume and greater market liquidity.
While futures and forward contracts are both a contract to trade on a future date, key differences include:
Futures are always traded on an exchange, whereas forwards always trade over-the-counter
Futures are highly standardized, whereas each forward is unique
The price at which the contract is finally settled is different:
Futures are settled at the settlement price fixed on the last trading date of the contract (i.e. at the end)
Forwards are settled at the forward price agreed on the trade date (i.e. at the start)
The credit risk of futures is much lower than that of forwards:
The profit or loss on a futures position is exchanged in cash every day. After this the credit exposure is again zero.
The profit or loss on a forward contract is only realised at the time of settlement, so the credit exposure can keep increasing
In case of physical delivery, the forward contract specifies to whom to make the delivery. The counterparty on a futures contract is chosen randomly by the exchange.
In a forward there are no cash flows until delivery, whereas in futures there are margin requirements and periodic margin calls.
Foreign currency swaps can be defined as a financial foreign currency contract whereby the buyer and seller exchange equal initial principal amounts of two different currencies at the spot rate. It is worth mentioning in this regard that the buyer and seller exchange fixed or floating rate interest payments in there respective swapped currencies over the term of the contract.
According to experts upon the maturity, the principal amount is effectively re-swapped at a predetermined exchange rate so that the parties end up with their original currencies. Foreign currency swaps are more often than not been used by commercials as a foreign currency-hedging vehicle rather than by retail forex traders.
Options allow investors even greater flexibility. Although more expensive than futures contracts, options are valued because they allow investors to choose whether to exercise a futures contract or not. The option-holder is under no obligation to buy or sell the underlying asset. Call options give an investor the right, but not the obligation, to purchase the indicated asset at a specified (strike) price by a certain date.
An investor who buys a call option is hoping, or betting, that the price of the asset will rise above the strike price. Put options give the option-holder the right, but not the obligation, to sell the security by a certain date. The purchaser of a put option is hoping or betting that the price of the asset will fall below the contract’s strike price. An option contract gives the its holder the “option” (or the right) to buy (or sell) the underlying item at a specific price at a specific time period in the future. There are two kinds of options. Buying a call option provides an investor the right to buy an asset while a put option gives the investor the right to sell the asset.
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