InvestmentsDec 6 2022

Understanding derivatives

  • Identify the different types of derivatives
  • Explain the benefits of derivatives
  • Explain the risks of derivatives
  • Identify the different types of derivatives
  • Explain the benefits of derivatives
  • Explain the risks of derivatives
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Understanding derivatives
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Given the current market turmoil where correlations across asset classes have dramatically come together, multi-asset investors should explore every tool in the box, and derivatives have a key role to play.

A derivative is any financial contract whose value is derived from another and is therefore dependent on the prices of their underlying assets.

These contracts are transacted between parties (the counterparties), enabling these counterparties to secure a future price in the underlying securities.

They are most often used to hedge against future price movements and as a way of limiting the risks of price swings in the underlying assets on which they are based. 

The derivatives market has grown to be incredibly extensive. 

The first concrete record of a derivative contract dates to about 600BC, when Greek philosopher Thales of Miletus used his knowledge of astronomy to predict a bumper olive crop and hired all the olive presses, so that when the harvest was ready, he would be able to let them out at a rate that brought him sizeable profit.

His prediction turned out to be correct, and the world’s first derivative trader became very rich.

From this very early start, the derivatives market has grown to be incredibly extensive. 

 

Derivatives are traded privately (over-the-counter, or OTC) or via an exchange.

The OTC market is larger, and unregulated.

As such, OTC derivatives generally have greater counterparty risk.

The advantage, though, is the ability to tailor contracts to very specific needs – it is like being measured for a bespoke suit, but with a weakened right of return if it splits at the seams.

On the other hand, exchange-traded derivatives are off-the-peg but come with more protections. 

In 2021, the total notional amount outstanding for OTC contracts in the derivatives market was about $600tn ($491tn), with exchange-traded volumes running up to about $10tn daily turnover in early 2022. 

By contrast, the global bond market is estimated to be about $130tn, and the value of stock markets globally slightly less.

Derivatives have myriad different structures and uses, but break down into a handful of fundamental types.

Forward and futures contracts

Forward contracts are the oldest and simplest.

These are OTC contracts to buy and sell an asset at a set price on a specific future date.

Derivatives do come with risks.

Futures are very similar but are traded on a recognised exchange.

In this case, the buyer and seller do not enter into a direct agreement but have an agreement with the exchange providing enhanced security.

Options

Unlike futures and forwards, options contracts are asymmetrical in relation to counterparty duties and obligations.

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