The Function of Derivatives

Derivatives include any security that derives its value in some way from the performance of another asset or assets. There are a lot of types of derivatives that are traded in the financial marketplace, encompassing a diverse range of products, including futures, forward contracts, various types of options, numerous types of swaps, and more,

In all cases, holding ownership of a derivative contract always involves its value being relative to something else, even in the case of swaps, where you may be entitled to an income stream but the income stream flows from something else, like payments on loans for instance or a return with a fixed rather than variable income stream.

Derivatives, particularly certain types, tend to be less transparent than other types of financial securities, especially those traded over the counter. Some derivatives may be of interest to individual investors, futures and options for instance, but they may not even be aware that other derivatives, mostly traded by institutions, consist of most of the value of the derivatives market as well as the overall world financial market.

Even though one may never become interested in trading in things like over the counter swaps, these financial products can end up having a big influence on one’s finances. An example would be the huge hit that financial institutions took from their exposure in mortgage backed securities during the recent mortgage crisis.

This had a profound effect upon the economy and also required huge bailouts to help get things back on their feet, and this indeed was a crisis with certain types of derivatives.

As a result of these risks, some have looked to demonize derivatives such as asset backed securities, and especially credit default swaps, which is like a form of insurance against credit defaults. When we see a lot of credit defaults, derivatives that base their value upon not defaulting are obviously going to take a hit.

Why Do We Have These Risky Derivatives?

We do need to understand that it is the defaults that cause the damage here, not the securitization of the risk, as the risk is there anyway, and the derivatives market functions to more efficiently allocate it.

As we tend to blame the messenger when we receive bad news, people have wanted to blame these types of derivatives for economic shortcomings. While it isn’t that there aren’t concerns with the way credit based derivatives are structured, for instance they could benefit from being more transparent, derivatives enhance rather than disrupt or interfere with economic efficiency.

What these instruments do is to transfer risk from those who are less prepared to bear it to those who are more prepared, but for this to work, people on both sides of the trades have to be in a position to make an informed decision.

If someone who is packaging a derivative does not fully disclose the potential risks, or even misrepresents it, then that may end up being a problem. When you hear stories like a certain town being talked into taking a position in credit swaps, and even after disaster struck, they weren’t really sure what they were into, this serves as examples of how this is not supposed to work.

If the risk is that you will likely lose all your money if we get a housing crisis, and then we get one and that’s what happens, you knew the risk and you took it on willingly.

Even the riskiest derivatives, the ones that involve underwriting risk such as writing options or selling credit default swaps, all involve degrees of risk that the bearers need to define properly and hedge against as they see fit.

Derivatives in themselves simply make this assigning of risk more efficient, moving them from those less inclined to bear the risks to those who feel more inclined or able, so derivatives in themselves make it easier to manage risk, not more difficult as is believed by many.

What Derivatives Actually Do

Derivatives serve two main purposes. Both involve a transfer or risk from one party to another, of some variety. Some derivatives assign risk to one outcome or another, such that both parties may be hedged.

An example of this dual hedging would be a futures or forward contract between a producer and a user, where the producer wants to hedge against prices going down, and the user wants to prevent having to pay more than a certain amount, both at a given time in the future.

There is always some sort of risk involved to each party in all financial security transactions, for instance if you sell a stock you transfer the risk of it losing value to the buyer, and are left with the risk of the loss of value that would occur if it gains in value.

Derivatives don’t work any differently than underlying assets in this sense, and the real difference between assets and derivatives is that with derivatives you can transfer a number of other risks and income streams between buyers and sellers.

Therefore, derivatives are much more flexible than trading asset based securities like stocks and bonds.

Why Do We Need or Want This Increased Flexibility?

We need to keep in mind that in order for the market as a whole to be most efficient, we need to provide the maximum opportunity and liquidity for people to trade. To the extent that either the supply or demand of anything is not brought together well, we will have market inefficiency, reducing access to things and also making their prices inefficient.

The reason why financial derivatives exist is that there is both supply and demand for them, for what each particular derivative offers. If you have one bank wanting to have some of its receivables which earn variable rates of interest instead get locked in at a certain rate, and another willing to offer that fixed rate, then you have a deal and a derivative contract is created.

This is of course just one example, but this is a good illustration of how derivatives transfer risk from the less to the more willing. This is the way insurance policies work as well, you cannot properly handle your house burning down but can handle the insurance payments, and the insurance company can handle the loss and is willing to take on the risk in exchange for these payments, so you have a market.

The very existence of any derivative tells us that there is a market for it, willing participants, and sometimes these contracts also get traded in public markets. This allows for further assignment, where someone who may be willing to take on the risk for a better price can get involved, leading to the better price discovery, liquidity, and efficiency that markets offer when they open up more.

This is all that really goes on with derivative contracts, regardless of the nature of them, whether it be to hedge against bad weather coming or to protect against loans or mortgages defaulting.

Trading in Derivatives

The use of derivatives is very widespread these days and while no one knows exactly how big the market is, its value these days is in the hundreds of trillions of dollars. This number does scare some people, but to be fair, this represents the notional value of the market, which doesn’t mean that this much money is on the line directly, for instance with systemic failure.

For example, an interest rate swap will involve a certain principal amount that is being used in the contract, but only the interest rates are at risk with it, not the principal. Losses are limited to interest rate fluctuations in other words.

With credit default swaps on the other hand, the entire amount is subject to loss, so the actual risked amount and the notional amount does differ depending on the derivative. Derivatives add up to a very big number though no matter how you slice it, well in excess of the stock or bond market.

One of the things that derivatives cover is credit markets, and the credit market is simply huge, and even a portion of that that derivatives cover is going to be huge as well.

Institutional traders trade the vast majority of the value of the derivatives market, with individual traders only comprising a fairly small portion of it. You would think by this that most derivatives contracts involve hedging, because this is what institutions usually seek to do, but as it turns out, most derivatives trading involves speculation, especially interest rate speculation.

The main reason for this is that anytime something is traded in a public market, speculation will drive a lot of the interest in the market. The commodity futures market is a good example of this, where the suppliers and the producers of the commodities only comprise a small percentage of those involved in trading them, with most of the other action being driven by speculation.

This is not a bad thing though, as almost the entire stock market is speculative, and the only time it isn’t, people are looking to hedge other forms of speculation. Speculation is what drives capitalism itself, including all investing and all business ventures.

What is critical though is that people who buy and sell securities become properly informed of the risks of what they engage in, and this is where derivatives can be a problem. Both people and even large institutions cannot be informed properly of the risks with securities, and there have been several cases where some of them have been brought down by not properly assessing and managing risk.

If these huge banks and other financial institutions, who can afford the best people money can buy, can lose billions on derivatives, this should give us pause for thought. It’s not that the risk with derivatives can’t be managed, and they certainly can, but we must always be vigilant to not taking on more risk than we can handle, especially with derivatives.