Investing Basics: A simple guide to derivatives

 

The earliest example of financial derivatives date back to Ancient Greece and the olive harvest. Today they are important in the global financial system and can be used for a variety of purposes – writes Christian Leeming.

 

They are often misunderstood and regarded as ‘complex’ and ‘risky’; whilst this may be true of some derivatives, many are relatively simple. When understood, and used properly they can be useful for fund managers – so what are they, how are they used, and what are the risks?

 

What  is a derivative?

 

A derivative is a financial instrument that derives its value from the performance of another financial instrument (the ‘underlying instrument’).

Derivatives are contracts traded between two parties, referred to as counterparties – one counterparty is the buyer, and the other the seller.

 Underlying instruments could be company shares, bonds or commodities. Derivatives exist in all financial asset classes. They can be used to speculate about the direction of an underlying asset price, or used to offset (‘hedge’) the risk of a loss.

Here are some examples:

 

 

Hedging with derivatives

 

Imagine a fund manager who manages a portfolio of shares for European based investors. The fund manager wants to buy shares in US-based Acme Inc because he things the share price is set to rise. However, Acme’s shares are denominated in dollars, and over time he thinks that the dollar will fall in value compared to the euro. 

A fall in the value of the dollar could seriously damage the value of an investment, even if the price of Acme’s shares rises.

So the fund manager could buy an exchange-rate derivative known as a ‘future’ for a small price. This locks in the exchange rate (in this example US dollar/euro) for a set period of time.

In doing this the manager knows that when he sells the shares the euro/dollar rate of exchange will be at the rate he has ‘locked in’; he has ‘hedged’ or offset his exchange rate risk. Of course he will not know what price the shares will be until he sells them because that is set by the market.

 

Speculating with derivatives

 

Another fund manager things that the share price of RightPrice supermarket is going to fall. One way to profit from a falling share price is to take a ‘short’ position which he can do using a derivative called a ‘Contract for Difference’.

Short positions are good for absolute return funds, because they aim to profit from falling share prices. Absolute return funds are ones that target positive returns whatever the direction of travel in the market.

The manager enters a short contract for RightPrice, and after the share price falls, exits the trade making a profit for his investors.

Of course – as with investing in traditional assets – in both examples, the trades could have gone against the fund manager.

If the value of the dollar appreciates against the euro, the Acme position will miss out on a currency gain, whilst a rise in the share price of RightPrice will result in a loss for a fund manager going short.

Therefore it is the fund manager’s view that carries the majority of the risk, while the derivative is simply the instrument used to express his view.  

 

The benefits of derivatives

 

Reducing risk: When used correctly, derivatives can be a good way of protecting (‘hedging’) investors against risks such as falling markets, interest rate rises and inflation.

Speed and cost: It could be quicker and cheaper for a fund manager to buy a derivative than to buy the underlying asset.

Choice: The range of derivatives on offer in financial markets is huge, helping to meet investor requitements.

 

The risks of derivatives

 

Default: The is a risk that either counterparty in the derivative trade may be unable to meet the contractual obligations. Fund managers can aim to limit this risk by carefully researching and limiting their exposure to each counterparty. Furthermore many contracts require assets to be pledged upfront as security, or ongoing payments to protect each counterparty from the risk of default.

Potentially large losses: If a fund manager makes the wrong investment decision some derivatives could cause large losses, particularly if combined with ‘leverage’. Leverage is in effect a form of borrowing, which increases exposure to the underlying security or market. Fund managers can control their losses via techniques such as stop-losses – an automatic order which closes out a position once a certain price has been reached.

 

At a glance

 

• Derivatives derive their value from the performance of an underlying asset
• They can be used to speculate about the direction of an underlying share price or hedge against a loss
• There are two parties in a derivative trade – a buyer and a seller
• The initial low cost and availability may make them more attractive than the underlying instrument
• Certain derivatives carry the potential for large losses

 

Glossary:

 

Counterparty: One of the parties that takes part in a financial transaction – ie the buyer or the seller

Hedge: To reduce the risk of adverse price movements by taking an offsetting position

Short: A position designed to profit from the fall in the value of an asset. Short positions can be achieved through derivatives.

Underlying: The financial instrument or factor from which the derivative derives its value. For example the price of a company’s shares.