BANKING AND FINANCE: DERIVATIVES

Introduction to Derivatives:  ”Necessity is the mother of invention”.   Humans have always been inventive through their sojourn in this world, and have come up with innumerable inventions that have made their lives comfortable.   Sometimes, though, they have done themselves and their world a lot of harm with their inventions.

While many of the human inventions fave fulfiled a genuine need, some inventions have served only their contrived needs, and yet  others have catered to the baser instincts of man, primarily, greed.

Into which of these above categories does the financial instrument called derivatives fit in?   Does it serve a genuine need or a contrived one, or only serves to pander to man’s greed?   In the light of the present Banking crisis, said to be triggered by the housing mortgage crisis, it would appear that derivatives fall in the last category, that is , to pander to man’s greed.

Be that as it may, it is worthwhile to study the subject of derivatives, if only to avoid such pitfalls in the future.

Definition:  A derivative is a kind of financial instrument that does not have a value of its own, but derives it from an underlying base.   This base may be an asset, or an index, or even a phenomenon.   In a way, a derivative resembles a parasite that feeds off its host.

Derivatives do not have an independent existence of their own.   They exist as offshoots of either assets like stocks, commodities, residential mortgages, etc.;  or indices relating to the stock market, consumer prices, exchange rates, etc;  or even phenomena like the weather conditions.   They derive their values and standing from the above assets etc, as listed above.

Purpose and Scope:  There are several purposes for which derivatives are put to use.   Sometimes it relates to genuine business transactions and the related risks, and sometimes to plain profit making.   Sometimes it is dictated by necessity, sometimes by inclination.   Some of the major purposes of derivatives are:

Risk Management:  The major purpose of having derivatives is to manage or counter risks faced in the business environment, especially that which cannot be dealt with conventionally.   It is also called Hedging.   Hedging occurs when the risk of the underlying asset is transferred through the medium of the derivative from one person to another.   A forward contract in a foreign exchange transaction like export and import is an example of hedging.  

Suppose an exporter of wheat based in Chicago exports a consignment of wheat to the United Kingdom, and expects the rate of the British Pound to decline against the U.S. Dollar, he may book a forward contract and sell his pounds at current rates against future delivery of wheat to the U.K.

Speculation:  Another purpose for which derivatives are used may be to book extra profits, or profits out of the ordinary, by taking advantage of the favorable movement of the value of the underlying asset.   Here the purpose of using derivatives is not hedging, or countering risk, but to scoop up additional profits.   This activity is called speculation.

Arbitrage:  Yet another purpose of derivatives is called as arbitrage, that is taking advantage of a lower current market value vis a vis future value of an asset.

Whereas the use of derivatives to counter business risks related to genuine busines transactions, may serve the purpose of utilizing derivatives, the same cannot be said of speculative activities, that have cause mayhem in the markets, more than once, in different parts of the world, notably the United States.

Types of Derivatives:  Like there are two types of medicines, viz, over the counter, and prescription ones, so also there are basically two types of derivatives, the Over-The-Counter derivatives(OTD), and the Exchange-Traded-Derivatives(ETD).

Based on these two classes of derivatives, there are three kinds of them like Futures, Options, and Swaps, that are briefly discussed below.

Futures and Forwards:  These are financial contracts with a committment to buy or sell an asset within a certain future date at today’s price.  That is future buy/sell at current rates.   While a forward contract is an examle of an OTC derivative, a futures contract is an example of an ETD.

Options:  These are contracts that entitle their owner to either buy or sell an asset without imposing an obligation to do so (buy or sell).   The option to buy relates to the call option and that to sell relates to the put option.  The price of the transaction is fixed at the time of making the contract, and is referred to as the strike price.   Another feature of this contract is the maturity date.   Here again, there are two options- the European option, and the American option.   Uner the European option, the owner may specifry maturity date only as date of Sale;  whereas in the American option, Sale is allowed to take place on any date upto the maturiey date.

Swaps:  Under this type of contract, the underlying values of currencies, bonds, commodities, stocks etc., are exchanged on or before a specified future date.

As can be seen from the foregoing, derivatives may be used to either hedge one’s risk, or to make super profits, or just settle for arbitrage.   As these instruments do not have a vlaue of their own, they are vulnerable to any kind of shift or change in the value of the underlying.   As such they may not be very reliable in countering risks unless the issues affecting the values of the underlying are properly understood and provided for.

It is pertinent to note here, how the derivatives have played havoc in the U.S. housing mortgage sector, that is the major reason for the current American Banking Crisis.   Based as they are, more on mathematical calculations than solid assets, or money’s worth, the derivatives, as financial instruments, were always a weak and vulnerable proposition for risk management, and when the first strong winds hit the derivatives market, they started spinning out of control, taking the whole banking industry with them.

From the way the derivatives market crashed, it has given rise to suspicions as to the competence of the ‘experts’ and ’specialists’ who spun out these instruments seemingly through a ‘divine’ combination of their super brains and computers.

As for the regulators, perhaps, they did not want to look like fools before the derivative whizkids, by posing mundane and ’stupid’ questions about what exactly these instruments were composed of, how they were valued, and indeed the necessity and viability of these financial instruments as a tool of risk management.   In the end, the regulators have ended up looking like bigger fools for not doing their mundane and ’stupid’ jobs.