Derivatives demystified

 

Super-investor Warren Buffett called derivatives “financial weapons of mass destruction”. But they can be a great way to reduce risk, says Doug Jopling, of Pie Funds.

If you ask people what ‘derivatives’ are, you may get blank looks – or hear them say derivatives caused the Global Financial Crisis (GFC) in 2008. 

However, most people can’t tell you what derivatives are and what they can be used for. So let me demystify them for you.

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What are derivatives?

A derivative is: A financial instrument whose value derives from, and is dependent on, the value of an underlying asset, such as a commodity, currency, or security. But what does this mean?

The earliest derivatives were used by the Sumerians and ancient Greeks, to buy and sell goods for an agreed future price. Here’s an example, to show how they work.

Prices are high now, so a farmer wants to sell next year’s crop at today’s prices, rather than taking the risk that prices might be lower next year. The farmer finds a buyer, who believes there’s a reasonable chance to profit from prices rising between now and the date next year when they’ve agreed to buy the crop from the farmer. 

The farmer has locked in a selling price he likes. The buyer has locked in a potential profit. They write down the terms. That agreement, documented in a contract, is the derivative.

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How are derivatives used?

Just like in ancient times, one of the main uses of derivatives now is in fixing future prices.

Airlines use derivatives to manage the volatility of a key cost, jet fuel. It agrees a price it will pay for the fuel in the future. That price may be more or less than the actual price at the time. But the advantage to airlines is the certainty of what it will pay, which enables it to plan ahead.

Businesses and investors also use derivatives to protect themselves against exchange-rate changes, fluctuations in purchase prices, and falling markets. 

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What do derivatives cost?

An upfront premium is usually payable, to set up the contract.

The party paying the premium does so because they believe the fixed price for selling or buying the asset in the future has more value than the money they are paying upfront.

What are the more commonly used derivatives?

Many types of derivatives exist and most of them are structured on the basis of agreeing on a future price for an asset. Common types of derivatives are futures, options, and swaps.

1. Futures and Options

A futures contract is an agreement between two parties about the price that will be paid, on a set date, for one party to sell an asset to the other. The asset is normally a commodity, like oil or gold, or shares or indexes.

An option is like a futures contract, but the buyer doesn’t have to go through with the transaction if they decide not to. 

For example, if you buy an option to purchase shares at NZ$10 each on a future date, and the shares are only NZ$8 when the option matures, it makes sense not to use the option as it’s cheaper to buy the shares at NZ$8 on the open market.

Options can be one of two types: A ‘call’ option, and a ‘put’ option.

A call option allows you to buy an asset at an agreed price in the future. You’d do this if you thought that the price of the underlying asset would be higher in the future than the agreed price, and you could make a profit.

A put option gives you the right to sell an asset at an agreed price in the future. You’d do this if you thought the price of the underlying asset would be lower in the future than the agreed price and, again, you could profit.

2. Swaps

Other types of derivatives include interest-rate and foreign-currency swaps.

Interest-rate swaps are used to agree a future interest rate and payment amount, which protects you from the risk of
rate rises.

Foreign-currency swaps do the same job for the risks arising from movements in countries’ exchange rates.

How are derivatives traded?

Derivative contracts can be traded over-the-counter (OTC) or on an exchange.

OTC derivatives are unregulated and form the majority of the derivatives traded. They allow more customisation for an investor than the standardised derivatives traded on an exchange.

What are the risks of using derivatives?

Investors should only use derivatives if they understand the risks. If you get your call wrong, you could see the value of your investments drop significantly. The main risks are:

Market risk. This is the likelihood of an investment being profitable – and whether the rewards outweigh the risks. For example, you could buy a put option to sell some iron ore at NZ$70 a tonne. But when the option matures, you find that iron ore is trading at NZ$80 a tonne. The option will expire, worthless, and you’ll lose the premium you paid for the option. However, if you’d bought the option because you thought iron ore could trade as low as NZ$60 a tonne, the certainty and peace of mind it gave you may mean the cost was worth it to you. 

Counter-party risk. This is the risk of the other party to the contract defaulting. This risk is higher on OTC markets, which are less regulated than trading exchanges. By using reputable exchanges and only dealing with brokers you trust, you can reduce this risk. 

Liquidity risk. This is the risk that you won’t be able to sell or buy a derivative, due to nobody trading right then. For example, let’s say you buy a derivative and decide to sell it before maturity, because your view changes. If nobody wants to buy it from you, then either you can’t sell it, or it may have a large ‘bid-ask spread’, which could cost you money.

Are derivatives “weapons of mass destruction”?

Derivatives can help reduce risks on trades. But they can also cause highly ‘leveraged’ businesses (with lots of debts) to suffer huge losses, if the value of the underlying assets of the derivatives swings in the wrong direction. 

This was discovered during the GFC, when some banks found themselves with worthless assets that nobody wanted, and governments had to bail them out. This arose because most derivatives trade on the OTC market, which has less regulation, so it meant the banks could write their own rules.

Warren Buffett said in 2008: “Derivatives are dangerous. They have dramatically increased the leverage and risks in our financial system.” 

In 2016, he warned again that the derivatives market is “still a potential time bomb” during periods of market stress. Some regulations were introduced after the GFC, but we can’t be sure the same problems won’t recur.

However, if derivatives are used carefully, and for the purpose for which they were intended, they can be useful in offering investors and businesses a way to hedge, or protect themselves from risks.

However, derivatives can be complicated. You should understand them before making any trades, and be wary of using them to speculate.

Definitions

Bid-ask spread: The amount by which the asking price exceeds the bid price for an asset in the market.

Derivative: A financial contract between a seller and a buyer, in which the parties agree to trade an asset at a predetermined date, for a set price. The price is derived from the fluctuation in price of one or more underlying assets.

Hedge: To limit or qualify something with exceptions or conditions, to protect you from the risk of prices dropping.

Leverage: The use of borrowed capital as a funding source to increase the potential return on an investment.

Over-the-counter (OTC): A trading platform that is not a formal exchange. For example, an interbank market between bank dealing rooms, or a dealer network.

View JUNO's full list of definitions here.

First published 20 August 2018.

Story by Doug Jopling, Pie Funds

JUNO does not contain financial advice as defined by the Financial Advisers Act 2008. Consult a suitably qualified financial adviser before making investment decisions. This story reflects the views of the contributor only. Content comes from sources that JUNO considers accurate, but we do not guarantee that the content is accurate.


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