updated on 17 January 2012
QuestionWhat are derivatives and why are they used by investors?
A derivative is a contract between two parties which derives its value from the value of an underlying asset at a future date. The underlying asset is referenced in the contract. There are various types of derivative contracts, including options and swaps, but the simplest form is the forward contract. Under a forward contract, the seller agrees that it will sell an asset to the buyer at a certain price, on a fixed date in the future. Such an arrangement might be useful where the parties wish to control the risk of the market value of the asset fluctuating in the interim period.
For example, an ice cream company agrees to sell 1,000 tubs of ice cream to a supermarket at £2 per tub in six months from the date of the contract. In six months' time, the ice cream company will be paid £2,000 and the supermarket will receive 1,000 tubs of ice cream. However, if at the date of settlement, the market value of each tub has fallen to £1.50, the supermarket will have paid £2,000 for ice cream it could have bought for £1,500. Similarly, if, at the date of settlement, the market value of each tub has risen to £2.50, the ice cream company will have sold £2,500 worth of ice cream for £2,000.
The main benefit of entering into the contract is that both companies are able to manage their finances in light of their contractual obligations, with the assurance that their cash flows will not be affected by sudden changes in the value of ice cream (the underlying asset). This is known as 'hedging'.
An option contract is another type of derivative which is the same as the forward contract, except that a particular party has the choice as to whether to buy/sell the asset at the date of settlement. Therefore, in the above example, if the supermarket had an option to buy the ice cream at £2 per tub and at the date of settlement the market value is £1.50 per tub, it may choose not to buy the ice cream - it has the right but not the obligation to buy the ice cream. It is likely that the ice cream company would have charged the supermarket a fee for the benefit of the option, which is worked into the price of the contract.
The other main type of derivative is the swap contract. This type of contract is more complex than those described above and involves the simultaneous exchange of future cash flow obligations, for example; the exchange of a fixed interest rate obligation under a loan for a floating interest rate obligation.
Trading companies, such as the ice cream company in the above example, can have various uses for derivative contracts, such as managing the risk of fluctuations in currency where there is an international element to its business; fluctuations in interest rates on loans that it may have taken out; and even changes in the weather. For example, the ice cream company may be conscious of the fact that its sales are, at least in part, dependent upon the weather, as customers may be less inclined to buy ice cream when it is cold. The ice cream company will have sales targets it expects to reach based upon past performance during summer months, but this could be significantly affected by poor weather. The ice cream company can enter into an option contract to manage the risk of a short and cold summer.
Derivatives can be physically settled so that the buyer takes delivery of the underlying asset. This would be appropriate where the trading company involved actually wishes to acquire the asset at the predetermined price. However, certain parties, such as banks and investors, may wish to benefit from fluctuations in the price of a particular asset without the hassle of actually dealing with it at the date of settlement. This can be done by agreeing to cash settle the contract.
For example, the current market value of a particular type of ice cream is £2 per tub. However, a trader believes that the price of that ice cream will have risen to £3 per tub in six months' time. He could enter into a future contract which states that in six months' time, he will buy 1,000 tubs of the ice cream for £2,000. If his prediction is correct, the counter party to the contract will pay the trader £1,000. If his prediction is wrong and the market value is in fact £1.50 per tub at the date of settlement, the trader will pay the counter party £500. If the market value is £5, the counter party would pay the trader £3,000. This is because the value of the future contract is the difference between the agreed price of the underlying asset in the contract and its market value at the date of settlement. Where contracts are cash settled, the parties neither possess the underlying asset nor wish to acquire it. They are simply using the market value of it as a reference point against which they can measure their predictions. On this basis, as the value of the underlying asset fluctuates, the contracts themselves can be traded.
The basic principles explained above form the foundations of a variety of other transactions, for example, where the underlying asset is shares in a company. They can be used by institutional investors to protect themselves against potential drops in the value of their investments and by pension funds to ensure that they are protected against the impact on their fund of fluctuations in salaries or size of the economy. There are numerous other ways in which derivatives are currently used, and new and innovative uses are continually being explored.
Jamie Pullen is a second-year trainee in dispute resolution at Field Fisher Waterhouse LLP.