Economist Guide to Finance, Chapter 9 ‘Derivatives Markets’

Levinson, M. (2014) Economist Guide to Finance, Chapter 9 ‘Derivatives Markets’ (253-274)

By Shaun Balderson

The term derivatives refers to a large number of financial instruments whose value is based on or derived from, the prices of securities, commodities, money or other external variables. Derivative trading is often attractive to investors due to how they can be involved in risk management, hedging, leveraged speculation and arbitrage.

However, whilst derivatives have made it possible for firms and governments to manage risks. Derivatives are far from riskless. They are often far too complex and difficult to understand. Dealers often do not fully understand what they are selling and buyers often do not fully understand what they are buying.  Because of this derivatives have come to public attention in recent years largely because of a series of losses from derivative trading and their role in a high number of financial disasters. For example, Metallgesellschaft lost 1.9billion in 1993, due to poor investments within the derivative market (particularly around oil futures). Procter and Gamble admitted to losing $157 million dollars and Gibson lost $20 million dollars due to complex ratio derivative trading. Barings, the British investment bank collapsed in February 1995 as a result of a $1.47 billion loss in exchange-trading options. Alike, Sumitomo, the Japanese trading company lost $3billion from derivatives and transactions.  Because of this aforementioned failure, derivatives are said to have played a key role in the financial crisis that crippled Thailand in the summer of 1997.

Derivatives have two basic categories

1. Forwards: contracts that set a price for something to be delivered in the future.
2. Options: contracts that allow, but do not require, one or both parties to obtain certain benefits under certain conditions. The value of an options contracts value must take into account the possibility that this option will be exercised.

Option trading only came around in 1973, when officials in the US approved a plan by the Chicago Board of Trade, a futures exchange, to launch an options exchange. Since then as investors have turned to the financial markets to help manage risk, options trading has become hugely popular. The value of contracts traded on options exchanges worldwide has increased from $52 trillion in 1996 to $71 trillion in 1998, before falling back to $62 trillion in 1999.

Most widely traded types of options

• Equity options (entitles the owner to buy or sell a certain number of common shares in a particular firm)
• Index options (based on an index of prices - any index as long as its value is continuously determined in a market.)
• Interest rate options (comes in two varieties) 1) Bond options (based on the price of government bonds, which moves inversely to interest rates) 2) Yield options set by deducting the interest rate from 100) (Example; $1m*(100-the rate).  In this nominal value declines as the interest rate rises.

• Commodity options (allows the buyer to lock in a price for a commodity in return for a premium payment)
• Currency options

New types of options

• LEAPS (long term equity participation securities - options that can last for up to three years into the future)
• Flex Options (non standard expiration dates and prices)

Gains and losses

• On balances there is no net gain or loss. However, one party's gain is always equal to another party's loss. No limit to someone's profit - no limit to someone's loss.

3 styles of options

• American style options (exercised at any time before their expiration date)
• European style options (exercised at any time near their expiration date)
• Cap options (have a predetermined cap price)