What is Derivate?

“A derivative is like a razor, you can use it to shave and make yourself attractive for your girlfriend, you can slit your throat with it or you can use it to commit suicide. ’(Anon. ) This statement describes to us the problems, and on the other hand rewards, that the proper use of derivatives can bring. The derivatives market has developed responding to the uncertainty about prices, and therefore provided a means of separating out this price volatility.

The tendency of the market to move up or down in what appears to be a random manner has brought about the need for financial products which will protect or hedge the investor against the ill effects of market volatility. Certain types of derivatives called Futures and Options might do just that if used properly. In this essay we look at certain types of derivatives called Futures and Options, and how hedgers / investors make use of them to their advantage as well as where the threats seem to lie when dealing with them in general.

These derivative markets allow hedgers to avoid risk by transferring it to speculators who seek it. We have all heard the phrase “keep your options open” and it is along these lines that the Options derivative has arisen. As we know options are contractual arrangements giving the owner the right, but not the obligation, to buy or sell something at a given price, at some time in the future. It is these Options in general that we want to address as they offer the investor the ability to create a wide variety of risk and return alternatives from the same underlying security.

Futures, being exchanged-traded forward contracts, have also provided another choice to suit the needs of the holder and the advantages for and against these will also be looked at. After looking at the Futures and Options we will turn our attention to discussing the cases for and against the needs of further regulating this market. This issue has been strongly reinforced since many big bets have gone wrong, such as the collapse of Barings and many others. Where do the faults lie which have led to these disasters and who if anybody is to blame?

These are matters that will need to be looked at. To begin with lets focus our attention on Futures contracts . Advantages / Disadvantages from the use of Future Contracts – As the market for future contracts is standardised and traded on the Stock-exchange ( LIFFE ) then a secondary market can exist and can be traded through the usual transaction mechanisms. – Holder of a futures contract is locked in an effective selling price therefore if he sells the contract against their position and then sees the market go up rather than down, he cannot take advantage of that upswing. If an investor wishes to take advantage of favourable yields but is aware this may increase interest rate exposure, the financial futures markets will provide an opportunity to hedge against possible loss.

Gearing effect of the margining system means investors can quickly loose 100% of their investment, which wouldn’t be likely if they invested directly in bonds and shares. -Holder of the contract can enter an offsetting contract with the same delivery month as the original contract and by this close out their position. Purchaser is forced to go through with the futures contract even if this is detrimental to them as mentioned earlier potential loss is unlimited. – Futures contracts can provide great gains or losses (symmetric risk ) – Clearing House system guarantees that all contracts will be fulfilled. – Risk of default is very low and the absence of some risk along with the presence of low transaction costs, ensures that the secondary market is highly liquid (i. e. A contract can be opened in one countries exchange and closed in another such is the high quality of the futures market. )

Offers a cash efficient means of taking position in a market as futures are traded on margin. This allows for a geared exposure to equity or interest rate risk. – You have simplified credit risk due to this margining system – Both the trader and investor have the ability to take a short position in the underlying security (i. e. sell something they don’t actually have. ) Stock indexed futures contracts allow small investors and traders to gain short-term exposure to a market without having to buy a portfolio of shares and earn the average rate of return, however by the expire date the owner of the futures would have to decide then whether to buy shares or new futures contracts (“rolling forward” position) – Fairly easy to price, at least compared to Options, with trading being done at good speed. We now turn our attention to consider the advantages and threats of buying Options contracts,

Advantages / Disadvantages from the use of Options – Small amount of money need be spent initially to gain exposure to large underlying securities position which leads to large percentage gains or losses however. -Options can become completely worthless if the security price moves contrary to the purchasers expectations by the expiry date of the option, normal shares only do if companies liabilities exceeds its assets. – The downside risk in money terms is smaller for a call option than for the underlying shares themselves. Options contracts only represent a potential claim on a companies asset, therefore holder has no direct relationship with the company. – Valuable if prices are likely to change. – Purchase of a call option is riskier than the purchase of an underlying share.

Holder can exercise contract or not depending on price or value of underlying security on expiry date, but is under no obligation to do so. ( right to exercise lies with holder not writer ) – Shares options are very volatile and therefore are a highly speculative investment. – With options you can obtain protection from a drop in share price. Valuing can use very complicated mathematics which is difficult to understand (Black-Scholes formula) – Different kinds of options are available such as Call ( option to buy at a fixed price ), Put ( option to sell asset at fixed price ) and double options.

This gives investor the choice to suit their needs. – Options are good for risk-management, including speculating, hedging ( eliminating the potential for both unexpected losses, and gains however ) and insurance ( they can be used to insure against losses although the premium may be costly. After having weighed up the advantages and threats from the use of futures and options contracts to the trader and especially to the investor we must now turn our attention to discussing whether or not further regulation and/or restriction is required. The concept of options being risky and speculative is not new and therefore its dealing was officially banned on the London Stock Exchange in the late 18th and early 19th century and for a short time in the mid 20th century.

This proves to us that the issue over the regulation, and / or restriction of derivatives, especially options and futures is not at all a recent one. However the case for more restriction has been strengthened in this last decade by massive losses being incurred by companies such as Barings Bank (860m) and the German industrial and chemicals trading group Metallgesellschaft ($1300m). Barings bank collapse brought about concerns over the regulators ability to supervise the financial institutions, however a closer look at the details allows us to come to a conclusion as to whether more regulation could have helped.

Even though the majority of the losses came from stock index futures it seems to have been their misuse and not their nature that caused it. The problem at Barings was the failure to segregate important jobs and supervise their internal control properly, it was unfortunate to have a dishonest employee in charge but that is besides the point. From what we see at the bank we would think that no extra regulation is needed but, would better supervision from outside have prevented the company from self-destructing ?

The answer seems to be yes, and that is why those for increasing restrictions believe we need more international harmonisation in this area, it is surprising that even after the collapse of Barings the British regulators did not get any real information from the Singapore regulators. They believe different treatments and supervision is not acceptable for such a difficult area to police. Other pro-regulation campaigners believe that if you don’t have the right controls in place you can’t catch the problem fast enough, (The Signs That Spell Danger. FT 16/11/95 ).

However this article also points out that the problem lies with overconfidence when using the derivatives, because in the past there have been many benefits, loose control and a lot of ignorance in the field. There is no doubt the financial institutions are very interwoven and can affect each other greatly, derivatives carrying very big figures and not being understood very well therefore would be a cause for concern. There are other issues which are brought up by those wanting more regulation such as: – The high degree of leverage common to derivatives.

The fear that companies using them could drag each other down, – The risk that banks are accumulating, and – The fact that derivatives are “ zero-sum games’ means someone will always loose out at anorther’s expense. However we must now bring forward the case of those who are against any further interference by outside regulators. They say that derivatives are basically being blamed for all these disasters just because they are not understood, and therefore this must be the problem, but looking closely at the mishaps proves that it is their misuse and not the nature of the derivatives to blame.

They go on to inform us that there is sophisticated risk-management systems in use to help react to sudden adverse movements, and that drills already have been carried out. They also say that the market is the best assessor of its needs if supplied with sufficient information and not outside regulations and restrictions. Basically according to them, derivatives must be used properly and be understood to supply benefit, however this raises the question of how can the average investor understand derivatives when the writers don’t ? CONCLUSION From what we have discussed it seems clear why derivatives have cause for concern.

They are very difficult to understand and as a result many are investing in them without enough information before hand. The advantages do outweigh the disadvantages when it comes to futures and options and therefore we could argue that it should be left up to the investor to decide what to do with his / her money. The problem gets worse when we come to the issue about more or less regulations and or restrictions. We get a picture of the corruption inside the offices of derivative sellers when we read books like “FIASCO, Blood in the water on Wall Street,’ by Frank Partnoy, and “Liars Poker,’ by Michael Lewis.

Both show the immorality and deceit that goes on when derivatives are sold by the traders and how they aim to “rip peoples faces off ’ . Frank Partnoy writes that “ shooting doves or clay pigeons was an excellent training for the more exhilarating real life kill, when the shrapnel of a complex financial instrument tore through the pocket of a wealthy unsuspecting human pigeon. ’ If this is the attitude of the sellers then investors definitely need more protection.

Some more supervision and international harmonisation on the market could result in the avoidance of future disasters but more self-regulation could be encouraged and set in play also. The bottom line is that anyone in the derivative business really needs to be more careful and have more control over what they are doing. Again Partnoy in his book FIASCO says, “ Most of us enter the investment business for the same sanity- destroying reasons a woman becomes a prostitute. ’ So if you do decide to invest you should take the advice of the Office of Kansas Securities Commission which is “Investigate before you invest. ’

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