In spite of the huge amount of discussion around financial derivatives, as well as the significant impact they have on our financial markets, the world of financial derivatives nevertheless remains rather confusing for both investors and the general public. Read on for an introduction to some of the basic concepts behind these unique financial instruments.

What exactly is a derivative?

financesIn the financial world, a derivative security is a type of financial contract whose value is derived from, or depends on, one or more underlying assets or variables; these assets are usually known simply as “underlying.” A wide variety of assets are used as underlying, including foreign currencies, commodities, fixed-income instruments, equities or equity indices, credit events, and even other types of derivative securities. Depending on the type or types of underlying used, the value of a derivatives contract will be derived from corresponding equity prices, commodity prices, exchange rates, interest rates, and the probability of particular credit events.

What is the main purpose of derivatives?

The principal function of derivatives is to satisfy user demand for cost-effective risk management; that is, for protection against the financial risks that changes in the prices of the underlying can bring. In other words, by using derivatives, investors can protect themselves from movement or fluctuations in exchange and interest rates, or commodity and equity prices. Essentially, the basic principle of derivative transactions is the transfer of risk from entities who are less able or willing to accept risk to entities who are more able or willing to do so.

Who participates in derivatives markets?

Participants in derivatives markets typically fall into two broad categories: “hedgers” and “speculators.” Hedgers are those who enter into a derivative contract for protection against negative changes in the values of either their assets or their liabilities. By entering a derivative transaction, hedgers ensure that a decrease in the value of their assets will be balanced by a corresponding increase in the value of the derivative contract.

stock-624712_1280Speculators, on the other hand, are those who seek to profit from the changes they anticipate in rates, credit events, or market prices by entering a derivative contract. But while the activities of speculators do appear to be inherently more risky than those of hedgers, many experts believe that it is not so easy to differentiate between the two categories of derivatives participants in practice, and that speculating and hedging are in essence flip sides of the same coin.

A wide range of entities now commonly participate in derivatives transactions, including insurance companies; fund managers; commercial, investment, and central banks; and other non-financial corporations. Furthermore, while hedging and speculating may be the most common motivations for trading in derivatives, they are not the only ones. Some firms, for example, enter derivatives contracts to obtain better financing terms, due to the common practice among banks of offering more advantageous financing terms to firms that participate in hedging activities, and thus reduce their market risks. Another practice, often used by fund managers, is to use derivatives to achieve specific asset allocation within their portfolios.

How long have derivatives been around?

Given the impressive rise of derivatives in recent years, it is easy to think of them as comparatively modern instruments, but in fact they have a long and varied history. In some form or other, derivatives have existed since the ancient societies of Mesopotamia and Rome, where contracts for the future delivery of commodities began to be used. In the 17th century, derivative trading on securities began to spread throughout Europe, and by the 18th and 19th centuries, banks rose to the forefront of derivative trading.

Why are derivatives so widely used today?

Derivative markets have grown strongly since the 1970s due to a number of fundamental changes that have occurred in global financial markets.

In 1971, the Bretton Woods system of fixed exchange rates collapsed, prompting an increased demand for hedging against the risk of changing exchange rates. Later that decade, the US Federal Reserve changed its monetary policy target instrument, thus promoting various derivatives markets. Then, in the 1990s, a new demand for hedging against credit risk arose from the emerging market financial crises, which brought with them a sharp rise in corporate bankruptcies.

Finally, innovations in financial theory, not to mention computer technology, have been a major contributing factor to the present popularity of derivatives. The development of options pricing research models in the 1990s provided a new framework for risk management by portfolio managers, and new technologies enabled the design and development of increasingly sophisticated derivatives. Today, the size of the derivatives market is enormous, and according to some measurements, actually exceeds that for bank lending, insurance, and securities.