Wednesday, July 31, 2013

What is a Derivative?

Ordinary people, i.e. most of us, may hear the word derivative and automatically associate the subject matter with Wall St. mobsters, politicians, and other unsavory characters.

A derivative implies a contracted agreement to value an asset, with the value derived from an underlying index.  Explaining the actual word derivative (vs. financial instruments per se): one could suggest that the perceived value (proposed selling price) of your home was derived from an index built of recent sales - of similar homes - in your neighborhood.

For financial instruments, derivatives imply a contract between two or more parties, whose value is based on an agreed-upon underlying financial asset, index or security.   

Most people have probably heard of employee stock options.  Employers may grant their employees individual rights to purchase their employer’s stock, at some future date, with the contract value derived from the underlying stock price at the time of the purchase.  An employee stock option is therefore a derivative, because its value is "derived" from that of the underlying stock.

Still awake?

Underlying instruments commonly used for valuation include assets familiar to many people, like bonds, commodities, currencies, market indexes and equities (or stocks).

Derivatives become increasingly more complicated when futures contracts, forward contracts, options, swaps and warrants become part of the mix.  These are the most common types of derivatives.  Derivatives are contracts and can be used as an underlying asset.

People even use derivatives based on weather data, such as the amount of rain or the number of sunny days, in a particular region.  Weather futures enable businesses to protect themselves against losses caused by unexpected shifts in weather conditions.

Derivatives are mostly used as instruments for hedging or mitigating risk, but they are also used for speculation.  

For example, an importer in Europe who may be required to pay for his purchases from an Asian factory in U.S. currency will be exposed to exchange-rate risk while waiting for his purchase order to be completed.  To hedge this currency exchange risk, the importer could purchase currency futures (often called forward cover) to lock in a specified exchange rate for the future payment, and currency conversion. 

Buying currency futures is usually a very common business practice for people in developing countries, when doing international business.  Because their currency’s exchange rate vs. U.S.$ may be volatile and unpredictable, this form of derivative is required in order to safeguard one’s business – and therefore also one’s clients – from massive price fluctuations for manufactured goods.

In the earlier part of my professional career - working in South Africa - I imported finished products, mostly manufactured in Asia.  At the time I was regularly purchasing currency futures without even knowing that these were derivatives.  I wasn't familiar with sophisticated naming conventions.  I was simply buying forward cover on currency exchange rates from my banker.  These futures were based on whatever the assumed effective exchange rate would be in a few weeks, at the time payment to the manufacturer of my products would be due for payment.

Speculators seek to profit from changing prices in an underlying asset, index or security.  A trader may e.g. attempt to profit from an anticipated drop in an index's price by selling (or "shorting") a futures contract.  

When derivatives are used as a hedge, it allows for risks associated with an underlying asset's price to be transferred between the parties involved in the contract, as described in my personal experience example, shared above.

Some derivatives are traded on securities exchanges, and these are then subject to U.S. Securities and Exchange Commission (SEC) regulations.  Other derivatives may be traded over-the-counter (OTC).

As usual, it is not the actual derivatives that are scary, spooky financial instruments, but rather the acts of a few individuals who use these instruments for personal gain, at the expense of others.  The victims are usually uninformed, and should therefore carry some of the blame for their financial losses suffered.

If you lack the knowledge to trade complex financial instruments, then stay away… and rather derive your return on investment from something that you are more familiar with.  It's as simple as that!

Many happy returns!