Derivatives – a simple guide
Mention derivatives and most people think of Nick Leeson, highly risky financial investments and City ‘wide boys’ making lots of money. Nicholas “Nick” Leeson (born 25 February 1967) is a former derivatives broker whose fraudulent, unauthorized speculative trading caused the collapse of Barings Bank, the United Kingdom’s oldest investment bank, for which he was sent to prison. Since leaving prison in 1999 he has become the CEO of Irish football club Galway United[1] and an after-dinner speaker.
But, insurance, farmers and complex mathematical formulas are as central to the concept of derivatives as the rowdy dealing pits depicted in the Eddie Murphy film Trading Places.
Derivatives are basically a way of allowing traders to hedge their bets.
‘Hedging’ is a good thing. It can protect companies and banks against unexpected developments, for example sudden falls or rises in the value of currencies or commodities.
Simple beginnings…
Initially it was commodities like wheat or coffee which were the subject of such trading.
Traders bought and sold ‘future’ contracts – an agreement to buy coffee, say, in three months time at a certain price – protecting themselves from the worry that a crop failure might drive up the price of coffee in the intervening months.
In the 1980s, financial futures began to dominate trading. This involves buying and selling futures or options on shares, bonds or currencies.
Some investment bankers began to turn hedging into a profitable business in its own right, developing progressively complex ways of hedging.
… can be mind-boggling
Swaps and options have become the next most common form of derivative trading after the original futures.
Options were invented because people liked the security of knowing they could buy or sell at a certain price, but wanted the chance to profit if the market price suited them better at the time of delivery.
Swaps are, as the name suggests, an exchange of something. They are generally done on interest rates or currencies. For example a firm may want to swap a floating interest rate for fixed interest rate to minimise uncertainty.
There are derivatives on almost all types of asset which are traded – the main four being bonds (which vary in price according to interest rates), currencies, shares and what can broadly be described as goods (metals, energy sources, agricultural produce etc.).
New ones are even being developed on catastrophes, such as earthquakes, and even on the creditworthiness of investors.
Win either way?
Derivatives are used widely by traders because, as a simple monetary value, they are much more flexible than the underlying products. The value is based on the price of the underlying product, but most contracts are settled in cash terms.
This enables banks, traders or investors such as George Soros to bet on price movements without having to deal with the actual assets. They could gamble, for example, on the frozen concentrated orange juice crop without having to buy an orange grove.
Derivatives can also be ‘leveraged’ – ie geared up to be worth many times the value of the underlying – so that if the price of the asset moves $1, the value of derivative could change by $10.
These instruments can also be used to insure against adverse price moves. In simple terms, an investor can buy a derivative which bets that the market will move against them so that they win either way.
Getting out of hand?
The image of derivatives as highly risky investments stems from the fact that contracts which may be worth millions if the market moves in a certain way cost only a fraction of that value.
Usually the market will not move that much and the contract will be settled or sold to somebody else for a small gain or loss. However if it does shift significantly big losses can be incurred.
On exchanges, traders have to pay any losses incurred on their position at the end of each day in order to prevent risks getting out of hand.
Banks have complex computer programmes to tell them how much they could lose if the market moves by a certain amount. Regulations require them to put money aside to protect against possible losses.
Derivatives have earned their “bad image” when these controls – as in the case of Nick Leeson of Barings Bank – have failed.
