Understanding Financial Derivatives: Types, Uses, and Risks

Introduction to Derivative Securities

A derivative security is a contract that specifies the rights and obligations between the issuer of the security and the holder to receive or deliver future cash flows—or to exchange other securities or assets—based on some future event. A derivative can have a large number of properties, so that its value depends on many factors. The terms and payments can be derived from the price of a security or commodity, published statistics, an event (such as default on payment), or something else. Derivatives that are fully standardized, like futures and many options, are generally traded through a securities exchange or futures exchange. Some derivatives are negotiated privately between parties, and their terms can generally be customized to meet those parties' needs. Standardized contracts traded on an exchange will generally have much greater liquidity.

The payments between the parties may be determined by: the price of some other, independently traded asset in the future (e.g., a common stock); the level of an independently determined index (e.g., a stock index or heating-degree-days); the occurrence of some well-specified event (e.g., a company defaulting on payment); an interest rate; an exchange rate; or some other factor. Some derivatives are the right to buy or sell the underlying security or commodity at some point in the future for a predetermined price. If the price of the underlying security or commodity moves in the right direction, the owner of the derivative makes money; otherwise, they lose money or the derivative becomes worthless. Depending on the terms of the contract, the potential gain or loss on a derivative can be much higher than if the parties had traded the underlying security or commodity directly.

One use of derivative securities is as a tool to transfer risk. For example, farmers can sell futures contracts on a crop to a speculator before the harvest. The farmer offloads—or hedges—the risk that the price will rise or fall, while the speculator accepts that risk with the possibility of a large reward. The farmer knows with certainty the revenue he will receive for his crop; the speculator will make a profit if the price rises but also risks a loss if the price falls. Speculators may trade with other speculators as well as with hedgers. In most financial derivatives markets, the value of speculative trading is far higher than the value of true hedge trading. In addition to outright speculation, derivatives traders may also look for arbitrage opportunities between different derivatives on identical or closely related underlying securities. Other uses of derivatives include gaining economic exposure to an underlying security in situations where direct ownership is too costly or is prohibited by legal or regulatory restrictions, or to create a synthetic short position.

Forward Contracts and Futures

A forward contract is an agreement between two parties to buy or sell an asset—of any kind—at a pre-agreed future point in time. The trade date and delivery date are therefore separated. Forward contracts are used to control and hedge risk, such as currency exposure risk (e.g., forward contracts on US dollars or Euros) or commodity prices (e.g., forward contracts on oil). The forward price will usually provide a good market estimate of the future price. One party agrees to buy and the other to sell at a forward price agreed upon in advance. In a forward transaction, no actual cash changes hands at inception. If the transaction is collateralized, an exchange of margin will take place according to a pre-agreed rule or schedule; otherwise, no asset of any kind actually changes hands until the maturity of the contract. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date (usually the next business day). The difference between the spot price and the forward price is the forward premium or forward discount.

Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in the underlying commodity and seek to hedge against the risk of price changes; and speculators, who seek to make a profit by predicting market moves and buying a commodity "on paper" for which they have no practical use. Hedgers typically include producers and consumers of a commodity. In traditional commodities markets, for example, farmers often sell futures for the crops and livestock they produce in order to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs so that they can plan on a fixed cost for feed. In modern financial markets, "producers" of interest rate swaps or equity derivative products will use financial futures or equity index futures to reduce or remove the risk on the swap. The utility of futures markets is considered to lie mainly in the transfer of risk and the increase of liquidity between traders with different risk and time preferences.

As an example of how a major corporation uses a forward contract, consider Lufthansa, the German airline, which contracted with Boeing to purchase aircraft in the mid-1980s when the value of the dollar was increasing. The price was set in dollars, and Lufthansa was concerned about the dollar strengthening and thereby increasing the Deutsche mark cost of the planes. In 1986, Lufthansa entered into forward contracts for the dollars required to pay for the aircraft. Although Lufthansa feared a strengthening of the dollar, what actually happened was that the dollar weakened. As a result, the forward contracts cost Lufthansa $140 to $160 million more for the planes than if the company had simply waited and purchased the dollars on the spot market.

Options and Financial Engineering

An option is a contract whereby the contract buyer has the right to exercise a feature of the contract (the option) on or before a future date (the exercise date). The writer (seller) has the obligation to honor the specified feature of the contract. Since the option gives the buyer a right and the seller an obligation, the buyer has received something of value. The amount the buyer pays the seller for the option is called the option premium. Most often the term "options" refers to a derivative security that gives the holder the right to purchase or sell a security within a predefined future time span for a predetermined amount. The specific features of options on securities differ by the type of underlying instrument involved. Real options are another common type—a real option may be as simple as the opportunity to buy or sell a house at a given price during some future period. The writer has the obligation to sell the house to the option buyer at the agreed price, while the option buyer is not required to purchase the house at all. Real options are an increasingly influential tool in corporate finance.

One can combine options and other derivatives through a process known as financial engineering to control the risk in a given transaction. The risk assumed can range anywhere from zero to infinite, depending on the combination of derivative features used. When using options for insurance, the option holder reduces the risk he bears by paying the option seller a premium to assume it. Because one can use options to assume risk, one can also purchase options to create leverage. The payoff from purchasing an option can be much greater than from purchasing the underlying instrument directly. For example, buying an at-the-money call option for two monetary units per share—totaling 200 units—on a security priced at 20 units will yield a 100 percent return on the premium if the option is exercised when the underlying security's price has risen by two units. By contrast, buying the security directly at 20 units per share would have yielded only a 10 percent return. The greater leverage comes at the cost of a greater risk of losing 100 percent of the option premium if the underlying security does not rise in price.