What is a “derivative”?

July 2, 2021

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4 min read

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Origins

Derivative transactions go way back… the first recorded transaction took place in around 600BC when the Greek philosopher Thales predicted a bumper olive harvest. He placed a deposit on the right to hire the local olive presses at a low rate in the future. The harvest was successful that year, which meant that demand for the presses was high. Thales profited by charging a higher price for their usage, whilst paying the low rate that he had initially agreed to hire them for. Crucially, in his initial arrangement, the philosopher’s deposit paid for the right but not the obligation to hire the presses. If the harvest had failed, he wouldn’t have had to hire the presses, and lose the entire cost of hiring them, he would only have lost the initial deposit. This is what is effectively known as an “option” today, a type of derivative.

Overview

Derivatives are financial instruments whose value is derived from underlying assets. Derivatives can be traded on a massive variety of underlying assets including shares, bonds, currencies, commodities or interest rates (you can even trade financial derivatives on the weather!).

There are three types of derivatives: futures/forwards, options and swaps.

Futures/forwards are contracts that oblige parties to enter into a transaction at a predetermined price and date in the future.  

Options, on the other hand, give the parties the right but not the obligation to enter into a transaction at a predetermined price and date in the future. They give you more flexibility than futures, and therefore you pay a premium upfront. However, you can’t lose any more than the premium.

Meanwhile, swaps are contracts between two parties to exchange the cash flows or liabilities from two different financial instruments for a set period of time. 

Let’s take the example of interest rate swaps: 

Jack takes out a fixed-rate mortgage, whereas Jill takes out a floating-rate mortgage. 

A fixed-rate mortgage charges a set interest rate throughout the term of the loan, whereas the interest rate of a floating-rate mortgage will vary with the market. Basically, Jack wants to fix his borrowing costs, whilst Jill wants to make sure that she is getting the variable market rate of interest.

Jack then decides that he no longer wants to pay a fixed rate, perhaps because he believes the cost of borrowing is going to decrease in the future. Meanwhile Jill has tight cash flow and wants to protect herself from rising interest rates in the future.

What do they do?

They treat each other as if they have swapped interest rates. If interest rates go up over the next year, Jack pays Jill the difference and vice versa.

Verdict

So, why are derivatives useful?

First,derivatives are often used for hedging risks. As demonstrated earlier, the philosopher was able to shield himself against the risk of a failed olive harvest by buying the right to hire the local olive presses but not the obligation to hire them. In finance, shielding oneself from risk like this is known as hedging. 

Second, derivatives can greatly increase leverage. Let’s say you buy a call option on a stock for £1 with a strike price of £50 and it’s currently trading at £48. The strike price is the price at which you can buy the underlying asset when you exercise the option. If the value of the stock rises to £55, you make £4 return on the £1 you invest (400% return). Whereas if you bought the stock for £48, you make 14.5% return. That’s leverage.

Third, derivatives can be used by investors to speculate on prices. This is where investors use derivatives to bet on the future price of the underlying asset in order to make profit. Derivatives can provide huge exposure to a market more easily and cheaply than using the underlying asset. Taking the last example, it is cheaper and easier to buy a call option that controls 300 stocks (£1 x 300 = £300) than it is to buy 300 stocks at £48 each (£48 x 300 = £14,400). A small move in the market will translate into a big move in your portfolio. For example, if the value of the stock rises to £55, you make £16,200 return on the £300 you invested (5,400% return).

However, derivatives are highly risky investments and therefore particularly dangerous in the wrong hands. Warren Buffet has famously described them as “financial weapons of mass destruction”. Highly leveraged institutions can make huge losses if the market moves against them. Taking the previous example again, if the value of the stock drops from £50 to £36, your options expire worthless, causing you to lose your premium (£300). If you bought a future that controlled 300 stocks, you would lose £4,200 (a -28% return on your investment). Whilst big gains can be made through trading derivatives, so too can big losses. So, although potentially very profitable, derivatives must be handled with care.

Report written by Emilia De Rosa

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