Financial Derivatives

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Financial Derivatives

What is a financial derivative? A financial derivative is a financial contract (between two parties) that derives its value from the value of some underlying asset. For example, a homeowner's insurance policy promises that in the event of a damage to your house, the insurance company will compensate you for at least part of the damage. The greater the damage, the more the insurance company will pay. Your insurance policy thus derives its value from the value of your house and therefore is a derivative.

An example of a derivative is the following: Party A makes an agreement with Party B regarding the price of gold. If the price of one ounce of gold in one year is above $300, Party A agrees to pay Party B the amount of $1. Otherwise, Party B will pay Party A $1. The agreement is a derivative since the outcome depends on the price of gold. Note that this agreement is a kind of a “bet" on the price moves of gold. In general derivatives can be viewed as bets on the price of something. The most common types of financial derivatives that we will discuss in this book are futures, forwards, options, and swaps.

Most Common Uses of Derivatives
Below are some of the motives for someone to use derivatives:
(1) to reduce (or hedge) exposure to risk. For example, a wheat farmer and a wheat miller could enter into a futures contract to exchange cash for wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the wheat miller, the availability of wheat.
(2) to speculate expected changes in future prices with the hope of making profit. In this case, speculation increases the exposure to risk. The potential gain or loss can be leveraged (i.e. magnified) relative to the initial investment.
(3) to reduce transaction costs, such as commissions and other trading costs.
(4) to maximize return on investments through asset management activities, tax loopholes, and regulatory restrictions. For example, a company can use derivatives to produce temporary losses to lower its taxes. We refer to this motive as regulatory arbitrage.

Perspectives on Derivatives
There are three different user perspectives on derivatives:
• The end-user perspective. End-users include corporations, investment managers, and investors. End-users use derivatives in order to achieve a specific goal or goals such as managing risk, speculating, reducing costs, or avoiding regulations.
• The market-maker perspective. These are traders or intermediaries between different end-users. They buy from end-users who want to sell (usually at a low price) and sell to end-users who want to buy (usually at a higher price.) Also, market-users might charge commissions for trading transactions.
• The economic observer such as a regulator or a research economist, whose role is to watch and even sometimes regulate the markets.
Derivatives Markets and Risk Sharing
Risk-sharing is one of the most important functions of financial markets. To illustrate this concept, consider auto insurance companies. These companies collect premiums for auto insurance policies. The total premiums collected are then being available to help those who get involved into car wrecks. Thus, those policyholders who had no wrecks in their records have basically lost their premiums. However, their premiums went to help those who needed it. A similar scenario occurs in the business world. Some companies profit and others suffer. Thus, it makes sense to have a mechanism enabling companies to exchange financial risks. Share risking mechanisms should benefit everyone.
Another example of risk sharing is the use of the so-called catastrophe bonds. For example, an insurance company that provides hurricane insurance for Florida residents will usually face large insurance claims in the case of a devastating hurricane happening. For that reason, the insurance company usually either issues or buys from reinsurers cat bonds enabling the company to share risks with the bondholders. Catastrophe bondholders receive interest rates at levels commensurate with the risk that they may lose all of their principal on the occurrence of a major hurricane.
The sponsor issues cat bonds and typically invests the proceeds from the bond issuance in low-risk securities. The earnings on these low-risk securities, as well as insurance premiums paid to the sponsor, are used to make periodic, variable rate interest payments to investors.
Sponsors of cat bonds include insurers, reinsurers, corporations, and government agencies.
Diversifiable Risk versus Non-Diversifiable Risk
Risk management is one of the topics discussed in portfolio theory. The risk level of an asset can be categorized into two groups: the diversifiable risk and the non-diversifiable risk. Before we discuss the difference between diversifiable and non-diversifiable risks, we need to first understand the term diversification. The act of diversification implies that an individual (or a firm) allocates his/her wealth among several types of investments rather than just one investment. In other words, diversification means spreading the risk of a portfolio by investing in several different types of investments rather than putting all the money in one investment. Diversifiable risk (also known as non-systematic risk) is a risk that can be reduced or eliminated by combining several diverse investments in a portfolio.

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