In this series of blogs on financial derivatives, we will look into what financial derivatives are, the motivation for using them and how they help manage various kinds of financial risks. We will also delve into the theory of quantitative finance that drives the valuation and risk management of financial derivatives.
Lets start by defining what a derivative is. A derivative is a financial contract that derives its value from one or more assets, known as the underlying(s). An underlying can be any asset (financial or otherwise) whose change in value can have a negative impact on a business. Examples are interest rates, currency exchange rates, stock prices, commodity prices and so on. Derivatives are used to mitigate and manage these risks. Following examples illustrate the use of derivatives to manage risks associated with assets.
Consider the example of a coffee producer who needs to invest in machinery in order to increase production. The machinery requires capital that the farmer does not have. The farmer goes to the bank, and obtains a loan that needs to be returned in six months. The farmer knows that he can return the loan using the money that he will make at the time of the harvest in six months time. There is however, a risk that the price of coffee beans might go down at the time of the harvest and the farmer might not be able to make enough money to repay the bank. The asset here is coffee and the uncertainty of future coffee bean prices poses a risk to the farmer. The farmer can mitigate the risk by entering into a financial contract with another party, lets say a super market. The super market agrees to buy his future produce at a fixed price. The fixed price that the farmer will get will be enough for the farmer to pay back the loan and make a profit. The risk associated with coffee bean prices has now been transferred to the super market. If the price of coffee bean goes down, the super market is obliged to buy from the farmer at a higher price compared to the market price (a loss for the super market). The super market makes a profit in case the price of the coffee bean goes up as it can buy cheap from the farmer. The farmer on the other hand, although, is getting a guaranteed price for his coffee, is potentially loosing money in case the price of the coffee go up in the future.
The contract signed between the farmer and the super market fixing the future price of coffee beans is called a forward contract.
A car manufacturer uses Aluminium heavily in its production process and hence is exposed to the fluctuations in Aluminium prices. Higher prices of Aluminium means that the cost of producing cars goes up resulting in reduction of profit margins. The asset here is Aluminium and its price fluctuation poses a risk to the profitability of the car manufacturer. The car manufacturer signs a contract with a bank for a fee that allows it the right but not obligation to buy a certain amount of Aluminium at a fixed price at any time within the next year. If the price of Aluminium stays below the agreed upon price, then the manufacturer buys it from the market and does not use the contract. If however, the price of Aluminium goes above the agreed upon price, then the manufacturer has the option to go to the bank and collect the difference between the market price and the price listed in the contract. This is an example of an option contract.
Some observations from the examples above:
In the above examples, derivatives have served as a vehicle for transferring risk from businesses to some one else for a price. In case of forward contract, the price paid by the farmer is the potential loss of extra profit in case the price of coffee goes up in the future. In case of an option contract, the price paid by car manufacturer is the fee for buying the right to buy at a potentially lower price (that may never be exercised) compared to the market in the future. The entities using derivatives in order to mitigate their risks are known as Hedgers.
The risk taker takes the risk away from the mitigating entity in anticipation of making money. In case of a forward contract, the risk taker hopes that the price of the underlying goes up so that it can buy the underlying cheap. In case of an option contract, the seller of the option contract hopes that the option will never be exercised and hence it can make money in the form of premium (fee charged for selling the option). In either case, the risk taker (known as Speculator) is taking a view on the future prices of underlying assets and is hoping to make money in case they are right (with the caveat of loosing money in case they are wrong).
What should be the fixed price in the forward contract or the amount of premium paid for the option? The answers to these questions are given by Quantitative Finance. Quantitative finance is an area of applied mathematics that involves building models for the valuation of derivatives. We will examine the fundamental concepts of Quantitative Finance during the course of these blogs.
Following are the key players of the derivatives market. Subsequent blogs will take a look at the role played by each of the players in greater detail.
It is important to note that same institution can play multiple roles described above, Large investment banks for example can act as dealers, brokers, speculators and so on.
Financial derivatives have been getting lot of bad press lately and the banking crises of 2008 has been blamed on derivatives. It is true that derivatives when misused can cause lot of damage. However, without a well-functioning derivatives market, the whole of the economy would cease functioning. The fundamental job of derivatives in transferring the risk to speculators is essential to the proper functioning of the wider economy. Without the derivatives, individuals and businesses would be exposed to the uncertainties in the prices of assets, resulting in instability of economy and the society as a whole.
This introductory blog on financial derivatives has covered:
I. The motivation behind the use of financial derivatives
II. Hedgers and speculators
III. The definition of quantitative finance
IV. The key players of the derivatives market