Thursday, 01 September 2005
In the fourth of a ten-part series into the world of finance, Mark Johnson explains why derivatives can be a force for stability in the markets, as well as highly risky.
Q. What are derivatives?
Mention derivatives to most ordinary people and you're likely to be met with blank stares, but they are, in their simplest form, a way of allowing traders in the markets to hedge their bets.
Contrary to popular belief, they can also bring stability to prices in the markets and can simplify and speed up trading. Derivatives exist for almost every type of asset that is traded, the main ones being bonds, currencies, shares and commodities.
Derivatives can also be traded publicly, on an exchange, or privately, in the over-the-counter (OTC) market. The former is widely seen as the safer market, due to the tight regulations surrounding the world's derivatives exchanges.
Q. Is derivatives trading a business?
The global market for derivatives is massive. According to figures from the Bank for International Settlements (BIS), turnover of global exchange-traded derivatives in the first quarter of 2005, as the combined value of trading in interest rate, stock index and currency contracts was some US$333 trillion.
This doesn't include the figure for OTC derivatives, which is estimated to be almost as large.
Q. What is the difference between a future, and option and a swap?
Futures and options are the most popular types of derivatives. Futures are simply an agreement made today to buy a certain amount of an asset, say oil, at a particular price, at a specific date in the future.
The key is that the price of the oil is agreed today, because a buyer may think the price will be higher in the future, whereas the seller believes the price may be lower than it is today.
Both parties, though, are trying to create price certainty for themselves. You actually agree the price today and pay up on the pre-arranged date in the future. Options, however, give you the right, but not the obligation, to buy something in the future.
For example, if you take an option to buy oil at $59 a barrel in three months, but then three months later the price is only $55, you wouldn't still want to pay $59, so you would simply let the option expire on the day the contract matures.
And because you only pay a very small amount to buy an option, you only lose a tiny fraction of what you would have lost had you locked yourself into a futures contract.
Moreover, if you are the seller and the price rises, you can let the option expire without taking any action and, again, you would only lose the small cost of the option.
Swaps are another popular type of financial derivative. Just as the name suggests, a swap can be exchanged for something else.
For example, the most popular types of swaps are interest rates or currency swaps, which may involve a trader wanting to swap a floating interest rate for fixed interest rate to minimise his exposure.
Q. What makes the price of derivatives go up and down?
Markets loathe uncertainty and everything from politics to the weather can affect price movements in the derivatives markets. Politically, if the world looks like it's becoming less safe, futures prices tend to rise.
And if the weather looks like it might ruin livestock or crop harvests, then, again prices will rise. Essentially, derivatives prices are usually based on what people think may happen down the line, in the future.
Obviously, none of us knows for sure what the future holds and this is why derivatives are often seen as highly speculative investments, just a gamble, or institutionalised betting.
But try telling that to a farmer who needs to ensure that he will not be paid rock bottom prices for his crop when it comes to harvest in three months time, just because there's more supply than demand in the market.
By offering futures and options on his crop, he can, to some extent, protect himself against future price falls. The same goes for the buyers of the crops - if the weather has ruined a grain harvest, prices could soar down the line, as supply will fall short of demand.
But, if the buyers have protected themselves with futures and options to buy at prices agreed months ago, then they won't be forced to pay more when the crops are ripe.
Q. Where are they traded?
There are derivatives exchanges all over the world.
The leading markets in the US are New York Mercantile Exchange (Nymex), where energy and metals derivatives are traded; Chicago Board of Trade (CBOT), which trades agriculture, interest rate and index metals derivatives; Chicago Mercantile Exchange (CME), where interest rate, stock index, foreign exchange, and commodities derivatives are traded.
In Europe, the main market is Euronext, which was formed when the exchanges of Amsterdam, Brussels and Paris merged with one of the world's largest derivatives markets, LIFFE (London International Financial Futures and Options Exchange).
Euronext trades leading European and international derivatives, including the German Bund, as well as index derivatives, such as FTSE 100 futures and options.
Q. Is there a derivatives market in the gulf?
The Middle East has virtually no formal derivatives markets, however the UAE will almost certainly create a stir across the global derivatives scene this year when the Dubai Gold and Commodities Exchange (DGCX) opens for business.
This exchange will initially list futures contracts in gold, to be followed by gold options, and futures and options on silver. The exchange also plans to introduce products based on fuel oil, steel, and freight rates in 2006.
Additionally, the Dubai International Financial Exchange (DIFX) says it will eventually offer derivative instruments once its market is up and running. Initial predictions are that DIFX will offer futures on equity and bond contracts that will already be traded on the new exchange.
Q. What are the risks associated with derivatives trading?
Derivatives have suffered from some pretty bad press in the past.
Perhaps the most famous case was that involving rogue trader, Nick Leeson, who caused the collapse of the world's oldest bank, Barings, when his derivatives trading schemes spiralled out of control on the Singapore Monetary Exchange (Simex).
Leeson's problem was that he continued to write options on the Japanese Nikkei stock index, expecting it to rise. However, an earthquake in Japan caused the Nikkei to drop sharply and Leeson's losses increased rapidly to more than US$1 billion, which proved too much for the bank to sustain.
The often volatile and high risk element of derivatives has kept them away from the ordinary investor. However, a number of markets now offer specially tailored derivatives products for this market.
In the UK, retail investors can buy securitised derivatives, such as covered warrants and certificates.
These are freely traded and are listed on stock exchanges and enable investors to have exposure to a wide range of underlying products such as shares, indices, commodities and interest rates without investing directly in the underlying product.
Markets
1. New York Mercantile Exchange (Nymex)
2. Chicago Board of Trade (CBOT)
3. Euronext (merger of exchanges in London, Amsterdam, Brussels and Paris
© 7Days 2005
