Derivative Markets

by Kelechi Okoye-Ahaneku

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

According to Levinson, the derivative market is the fastest-growing part of the financial markets in recent years.Over-the-counter derivatives are transactions negotiated privately between two parties, known as counter parties, without the intermediation of an exchange. In general, one of the parties to a derivatives transaction is a dealer, such as a bank or investment bank, and the other is a user, such as a non-financial corporation, an investment fund, a government agency, or an insurance company. The term derivatives refers to a large number of financial instruments, the value of which is based on, or derived from, the prices of securities, commodities money or other external variables.Derivatives fall into two basic categories: 

1)Forwards- these are contracts that set a price for something to be delivered in the future.

2)Options- these are contracts that allow, but do not require, one or both parties to obtain certain benefits under certain conditions. The calculation of an option contracts’s value must take into account the possibility that this option will be exercised

• The derivatives market barely existed in the late 1980’s.The business is seen to have burgeoned in the 1990’s as investors discovered that derivatives could be used to manage risk or, if desired, to increase risk in the hope of earning a higher return. Derivatives trading has also been controversial, because of both the difficulty of explaining how it works and the fact that some users have suffered large and highly publicised losses. Whats more is that derivatives can allow banks and companies to take risks that are not clearly disclosed on financial statements, and can provide a means of circumventing regulations that restrict investments by insurance companies, government agencies and other entities. The notional principal, or face value, of outstanding over-the-counter derivatives was $633 trillion at the end of 2012
• Types of Risk
• Counterparty risk- For all exchange-traded options, the exchange itself becomes the counterparty to every transaction once the initial trade has been completed, and it ensures the payment of all obligations. This is not so in the over-the-counter market, where derivatives are normally traded between two businesses. 
• Price risk- A derivatives dealer often customises its product to meet the needs of a specific user. This is unlike exchange-traded options, whose size, underlying and expiration date are all standardised.
• Legal Risk- Where options are traded on exchanges, there are likely to be laws that clearly set out the rights and obligations of the various parties. The legal situation is often murkier with regard to over-the-counter derivatives.
• Settlement risk-The exchange makes sure that the parties to an option transaction comply with their obligations within strict time limits. This is not the case in the over-the-counter market. Its seen that central banks in the biggest economies have been trying to speed up the process of settling claims and paying for derivative transactions, but participants are still exposed to the risk that transactions will not be completed promptly.
• Types of Derivatives
• Forwards- Forwards are seen to be the simplest variety of derivative contract. A forward contract is an agreement to set a price now for something to be delivered in the future.
• Interest-rate swaps- An interest-rate swap is a contract between two parties to exchange interest-payment obligations. Most often, this involves an exchange of fixed-rate for floating-rate obligations. For example, firm a, which obtained a floating-rate bank loan because fixed-rate loans were unattractively priced, may prefer a fixed payment that can be covered by a fixed stream of income, but firm B right prefer to exchange its fixed-rate obligation for a floating rate to benefit from an anticipated fall in     interest rates. 
• Currency swaps - Currency swaps involve exchanging streams of interest payments in two different currencies.   If interest rates are lower in the euro zone than in the UK, for example, a British company needing sterling might find it cheaper to borrow in euros and then swap into sterling. The value of this position will depend upon what happens to the exchange rate between the two currencies concerned during the life of the derivative.
• Interest-rate options-This category involves a large variety of derivatives with different types of optionality. A cap is an option contract in which the buyer pays a fee to set a maximum interest rate on a floating-rate loan
• Commodity derivatives-Commodity derivatives function much as commodity options, allowing the buyer to lock in a price for the commodity in return for a premium payment. Commodity options can also be combined with other sorts of options into multi-asset options.
• Equity derivatives - Over-the-counter equity derivatives are traded in many different ways. Synthetic equity is a derivative designed to mimic the risks and rewards of an investment in shares or in an equity index.

Credit derivatives - Credit derivatives are a comparatively new development, providing a way to transfer credit risk, the risk that a debtor will fail to make payments as scheduled. The instrument used for this purpose is a credit default swap. Credit default swaps provide for the seller to pay the holder the amount of forgone payments in the event of certain “credit events” which cause a particular loan or bond not to be serviced on time.

Derivatives have also left its mark on the financial markets. Indeed, the global market for derivatives covers just about every asset in the world and there are even derivatives for hedging against the weather. Since derivatives essentially are traded on the basis of the value of the underlying asset, any disproportionate fall in the value of the underlying asset would cause a crash in the derivatives designed for that purpose. And this is what happened in the summer of 2007 when the housing market in the US started to go bust. Of course, the clever bankers had devised derivatives for such an eventuality as well and this was seen as an acceptable way of hedging risk. So, the obvious question is that if both sides of the risk have been hedged, then there should not have been a bust in the derivative market. The answer to this is that those investment banks and hedge funds that had found the right balance between the different hedging instruments survived the crash whereas the other banks like Lehmann that were highly leveraged because of their exposure to the subprime securities market collapsed.