Risk Takers: Uses and Abuses of Financial Derivatives by John E Marthinsen

Risk Takers: Uses and Abuses of Financial Derivatives by John E Marthinsen

Chapter 1
Primer on Derivatives
Learning to use derivatives is a bit like developing an athletic or musical
skill. The key to success is understanding the fundamentals. This chapter
focuses on the two most important derivative instruments, forwards and
options, and explains how they are like Lego blocks in the sense that they
are useful by themselves and for constructing more sophisticated structures.
What Are Derivatives?
A derivative contract is an agreement between two or more parties (also
known as counterparties), whose value is based on movements in the price
of an agreed-upon underling asset or factor, such as a stock, bond, currency,
credit rating, or index. It is called a “derivative” because changes in its value
are derived from changes in the price of a specifically defined underlying
asset or factor, which is called, for short, the “underlying.”1 Every derivative
contract has an underlying, whose price, at contract initiation, is called the
current market price and, at maturity, the maturity market price.
Among the most popular, derivative underlyings are financial securities
(e.g., equities, bills, bonds, and interest-earning deposits), commodities (e.g.,
agricultural products, precious metals, and energy), and currencies (e.g.,
euros, pounds, Swiss francs, and yen). However, there are active derivative
markets in unexpected areas, as well, such as weather conditions,
creditworthiness, and stock indices. They are “unexpected areas” because
their underlyings cannot be delivered or would be extremely difficult to
deliver at maturity. In such cases, cash settlement replaces actual delivery.
Almost anything can serve as the underlying for a derivative contract. To be
successful, it must be something that can be valued and is attractive enough
so that many people are willing and able to buy and sell it.
Every derivative contract has a buyer and a seller, who are called
counterparties. Consequently, there is a buyer counterparty and seller
counterparty for every derivative contract traded. When a derivative is
initiated, its master agreement establishes important terms, such as the price,
quantity, quality, and date on which the contract will be settled in the future.
Derivatives have one major function, which is to transfer risks from
those who are either unwilling or unable to bear them to those who are
willing and able to do so. They are not sources of funds but, often, are
attached to debt instruments, which are sources. Similarly, these financial
instruments do not create wealth because the gains to one counterparty are
matched by losses from the other; but make no mistake about the broader,
beneficial role derivatives play in our real and financial markets. By
improving the allocative efficiency of national and international financial
systems, increasing liquidity, and improving price determination, derivative
instruments create a bigger pie for everyone to share.
Who Buys and Sells Derivatives?
Derivatives are bought and sold by end users, arbitragers, and
intermediaries. End users are individuals, businesses, and financial
institutions, which utilize these financial instruments to hedge or speculate.
Hedging neutralizes or mitigates the risks of an existing or expected
position, and speculation intentionally increases these risks in order to earn
profits.
Arbitragers are not interested in owning derivatives. Rather, they make
small and (virtually) risk-free profits by simultaneously buying and selling
them. In this way, they benefit from tiny discrepancies in the prices of
financially identical (or similar) contracts offered on different markets.
Intermediaries make up the final group of participants in derivative
markets. They connect buyers to sellers and are the creators of innovative
derivative products. Dealers, brokers, banks, exchanges, and an army of
financial wizards earn revenues from commissions, fees, and the difference
between buy and sell (i.e., bid and ask) prices of derivative contracts. Market
makers are intermediaries that quote customers both bid and ask rates, but as
volatility increases, the spread between these buy and sell rates widens.
Where Are Derivative Contracts Bought and Sold?
Derivative contracts can be traded either over-the-counter (OTC) or on
exchanges. Over the counter trades are mainly for non-standardized

Risk Takers: Uses and Abuses of Financial Derivatives by John E Marthinsen