Financial derivatives are risk management instruments that derive their value from an underlying asset such as interest rates, government bonds or currencies. Financial derivatives are relatively new financial instruments; having come about in the early 1970s. There were a number of factors that helped financial derivatives to gain popularity, including: The reinstitution of variable monetary rates, the rise of computer technology and the globalization of markets and economies. Financial derivatives allow investors to hedge risk when investing in asset classes that are subject to unexpected and unpredictable price fluctuations. Some derivatives gain their value from commodities that are not considered financial derivatives such as oil, natural gas or corn. Financial derivatives are increasingly tracked through broader indexes that emulate securities indexes. There are several categories of financial derivatives that are widely used in today's market; these include: Futures and forwards; options, and; swaps. Financial markets are very innovative; the rise in popularity of derivatives instruments exemplifies how creatively markets are able to package and manage risk. There is seemingly no end to the ways that assets can be sliced and bundled to mitigate risk. Derivatives are instruments that help investors manage risk particularly where there is volatility. Tightening credit markets and fluctuating interest rates have spawned a number of credit derivatives that include credit/debt swaps and collateralized debt obligations. Likewise, the volatility of real estate markets has increased the popularity of real estate derivatives.
Keywords Credit Derivatives; Financial Instruments; Hedging; Real Estate Derivatives; Underliers
Finance: Financial DerivativesOverview
"Derivatives are financial instruments that have no intrinsic value, but derive their value from something else. They hedge the risk of owning things that are subject to unexpected price fluctuations, e.g. foreign currencies, bushels of wheat, stocks and government bonds" (Davies, 2007, ¶2). There are three main types of financial derivatives: Futures and forwards; options, and; swaps. Derivatives are a risk management tools used by investors to mitigate risk in any market or with any "underlier" or underlying asset class that has risk associated with its particular market. The scope of this essay concentrates on financial derivatives and discusses some of the more common asset classes on which financial derivates are based. Some of the more common assets that financial derivatives are based upon are: Bonds, currencies and interest rates. In essence, any underlying asset that is subject to market volatility and price fluctuations is a good candidate for being the basis for a financial derivative.
Financial derivatives have really only been around since the late twentieth century. Prior to creating futures trading that is tied to financial instruments; futures were exclusively tied to commodities (most of which were agricultural). In the late 1960s and early 1970s, there was already talk amongst some of the more innovative leaders and economists in the U.S. about creating a new class derivative based on underlying financial instruments. There were several watershed events that took place in the early 1970s that ushered in the era of futures trading based on financial instruments.The Commodities Future Trading Commission
One of the pivotal events that brought about the inception of financial derivatives was the establishment of the Commodities Future Trading Commission (CFTC) in 1974. Several years prior to the establishment of the CFTC, there was talk of establishing interest rate futures, but since interest rates were clearly "securities," this proposal did not fall under the "then current" definition of a commodity. It was the CTFC Act of 1974 that "redefined what a commodity was and it also granted exclusive jurisdiction by the CFTC to retain that [jurisdiction]. The Act is credited with defining futures stock indexes and interest rates" (Collins, 2007). On September 11, 1975, the CTFC approved the first futures contract based on a financial instrument; it was known as the Government National Mortgage Association Certificates (Ginnie Mae).Merc & Leo Malmed
Leo Malmed became head of the Chicago Mercantile Exchange (Merc) in 1969. At the time, the exchange traded futures based exclusively on meats and other agricultural products. At the time Leo Malmed became head of the Merc, the exchange was just in meats; according to Malmed, even butter and eggs weren't trading. Still he didn't give up and by his own admission tried trading futures on many different commodities including: Apples, turkeys, shrimp, potatoes and oranges. All these products had one thing in common; they were all agricultural commodities and they had limited market appeal. In his own words, Malmed stated his concern; "I was deathly afraid that I'd be chairman of a single product exchange. Anything happened to that product, you're out of business." Mr. Malmed started asking himself if currency futures could be traded like pork bellies and beef. Malmed understood that if currency futures were possible, then it was conceivable that any financial instrument could be used to trade futures (Ryan, 2006). It was at this time that the fixed rate monetary exchange system (as had been established in the Bretton Woods Agreement of 1944) was being abandoned. Malmed's idea was to establish a way to trade foreign exchange futures that would be based on the floating exchange rates. As Malmed pointed out, agricultural commodities were limited and had limited appeal, but with financial instruments it was "anything you want" (Ryan, 2006).Risk
Because financial derivatives are based on assets that are inherently risky themselves (for example interest rates), financial derivatives can also be risky financial instruments. Like many financial market instruments, the higher the risk, the greater the chance for high financial rewards. Derivatives allow for investors to look at industries and sectors that face risk and use a mechanism (derivative) to price and transfer that risk. Understanding where current risks are and where future risks will be is crucial to the success of effectively using derivatives as an investment tools (Collins, 2007).
Warren Buffet is famous for making the following statement about derivatives in 2002. "We view them as time bombs both for the parties that deal in them and the economic system ... In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal" ("At the risky end of finance," 2007). Financial derivatives have been described by many proponents as financial instruments that threaten the status quo; they are also credited for making opaque markets more transparent. The love/hate relationship with financial derivatives will continue in the future and new derivative products are introduced to investors. As with most change, there will be reluctance, speculation and fear regarding new derivative products. As investor confidence in derivatives rises, however, markets and investors will embrace instruments that will help them manage the risk/return paradigm. This essay discusses both sides of the risk/return spectrum of financial derivatives: Do derivatives disperse risk or boost it?Applications
There are three main types of derivatives that fall under the broader heading of financial derivatives. These derivative types are: Futures and forwards; options, and; swaps.Forwards & Futures
Forward and futures contracts are one category of financial derivatives. Forward and futures contracts are similar in that they are contracts that allow for the purchase or sale of an underlying security or asset with the actual delivery date to occur in the future. A future or forward contract allows for the buyer to "lock in a price today for a transaction that will take place in the future" ("Forward and futures contracts," 2007).
Over the Counter (OTC) derivatives are the fast growing financial instruments in modern capital markets. OTC derivatives are hitting the mainstream and allowing fund managers to add long and short term strategies to retail investor's portfolios. OTC derivatives are both novel and complex instruments and their growing popularity is straining the operational infrastructure that supports the markets. OTC derivatives were initially traded by the brokerage arms of investment banks to structure hedge fund investments (Stillabower, 2007). Today, OTC derivatives are straining the operational platforms of firms that don't have the capacity and systems that have been built into exchanges. The risk of OTC financial derivatives has been outlined in the table, above, but that is not stopping institutional and retail investors from pursing OTC financial derivatives in droves. "There's a "need to improve the processing, servicing and valuation of OTC derivative instruments" as they become more widely accepted as financial instruments that mitigate risk and diversify investor portfolios (Stillabower, 2007).Options
Options are defined as the right, but not the obligation, to buy or sell a specific amount of X (currency, index, debt) at a specific price during a specific period of time. Another way of stating what an options contract is, is to say that two parties have the right to engage in a future transaction of some underlying security. The buyer of the option is...
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