DERIVATIVE SECURITIES

The term derivative is commonly used to describe a type of security whose market value is directly related to, or derived from, another traded security. Option, futures, and forward contracts are examples of derivatives as well as stock warrants, swap agreements and other more exotic variations. A simple example of a derivative would be a call option on a company's stock. The most important determinant of the price of the option is the current price of the company's shares on the open market (the underlying asset).

The development of derivative securities has facilitated the market for risk associated with a certain asset, apart from its actual ownership. Consider the following example: A farmer wishes to hold his corn crop until spring because prices tend to be higher in spring than in the fall. However, he doesn't like the uncertainty that comes with waiting six months to know the value of the corn crop. Futures contracts would allow the farmer to keep the corn until spring yet lock in the current price. The contract would, in effect, sell off the price uncertainty to someone in the market that is willing to hold it. In this case the farmer has hedged his risk of a price drop. The person who accepts the risk is engaged in the practice of speculation. It was the need for this type of transaction that spawned the first derivative securities markets; medieval Japan, for example, was known to have organized trading in rice futures.

OPTIONS

Call options are securities that allow a person to buy a stock at a specified price, known as the exercise (or strike) price, on or before a certain date, known as the expiration date. For example, IBM call options at 50 would refer to a security that allows the buyer to acquire a share of IBM stock for $50 any time on, or before, the expiration date. As long as the price of IBM is greater than $50, exercising the option would generate positive cash flow when the stock is purchased by the option holder and then sold to another investor. If IBM stock sells for less than $50 there is no obligation to exercise (and lose money), hence the name option. The amount of money paid to acquire the option is known as the option premium.

Put options are similar to call options except that they give the buyer the right to sell stock at a specific price instead of buying it. Following the previous example, if IBM stock is below $50 then the buyer of the option could exercise the option and generate a positive cash flow. Here, the stock is purchased for less than $50 then immediately sold at the exercise value. Once gain, the buyer of the option is under no obligation to exercise.

On the opposite side of every option purchase is someone who agrees to sell either the put or call. This investor accepts the premium payment up front, and also accepts the risk that the buyer will later exercise the option, forcing them to pay the buyer whatever the amount of positive cash flow the exercise generates. The premium is determined in the open market as the value that equates buy orders with sell orders.

FUTURES AND FORWARD CONTRACTS

Futures contracts are agreements to buy or sell assets at some time in the future. The first futures markets were for agricultural commodities such as corn and wheat, but now items such as Treasury bond futures, foreign exchange futures, and stock index futures trade far higher volumes than do agricultural futures.

The unit of trade on the futures exchange is one contract, which varies in size with the amount of the commodity traded. For example, a September corn futures contract could be an agreement to buy 5,000 bushels of corn in September at the stated price. A Treasury bond futures contract may require delivery of $100,000 face value of treasury bonds at the stated date. The futures price is the price that matches buyers of these contracts with sellers.

In theory, no money needs to change hands when the agreement is made since it is a future sale or purchase; however, a cash deposit, called a margin, must be established up front. During the period prior to the expiration of the contract, gains and losses from the movement of the futures price are charged directly to the investor's margin account. This process, which occurs on a daily basis, is called "marking-to-market". For example, if the futures price of corn goes down $.10 a bushel, then anyone holding a previously purchased contract would be asked to pay the extra $.10 per bushel on the aggregate quantity. The party who sold the contract would be paid the amount over market price that they are due immediately.

Forward contracts work similarly to futures except they are not traded on formal exchanges, and they are not marked-to-market. Gains and losses accrue until the contract's expiration date or until the holder of the contract reverses his position. Forward contracts are used mainly by large corporations and financial institutions to hedge foreign exchange risk.

OTHER DERIVATIVE SECURITIES

Warrants are essentially call options given by a company for their own stock, usually as "sweetener" along with a bond issue. When this occurs, the buyer of a bond with an attached warrant will receive the bond and a call option with an expiration date of several years or more. Convertible bonds are very similar except that the bond is converted into stock if the holder chooses to exercise the option.

Interest rate swaps are agreements to trade fixed interest rate payments for floating interest rate payments in return for a premium. Currency swaps are agreements to exchange debt in two different currencies. Although these, and other derivatives, are complicated, they can generally be analyzed as extensions of either the basic options or basic futures contracts. In fact, the diversity of the derivatives markets is so great there are even options on futures contracts.

HEDGING

Almost all participants in derivative securities markets may be classified as hedgers, speculators, or arbitrageurs. However, the same participant may fill different roles at different times.

A market participant is said to be hedging if he uses the derivative market to manage his exposure to risk. Common examples of hedging include:

• A food processor with commitments to buy grain at market price in the future will buy futures contracts now so that future increases in grain price will be offset by gains in the futures market.
• A large international pension fund buys or sells foreign currency forward so that any losses in value of their foreign stock holdings due to currency movements will be offset by gains in the value of the forward contract.
• A corporation that plans to take over another company may buy stock index futures to protect against a general market price increase during the time that shares are being acquired. If the company is going to hold a large position for a long time they may also use call and put options to protect against stock price movements. For example, buying puts will compensate for lost value if the stock price falls. Selling calls will allow the company to pay for the puts, and if the stock price goes up, the losses on the calls are compensated for by the fact that the stock itself is worth more.

In general, hedging with futures and forward contracts requires taking a position opposite to the position one holds in the primary market.

Generally, options hedging involves buying puts or selling calls to protect against declines in the value of stock one owns. Other, more complicated variants also exist.

SPECULATION

Speculators are derivative securities market participants who do not hold the underlying assets. A speculator does not buy futures contracts because he expects to purchase a commodity later. A speculator buys futures contracts merely because he believes that the price of the commodity will increase beyond the current price. If this happens the speculator makes money, without ever needing to buy the actual asset. The drawback is that should the futures price of the commodity fall, the speculator will lose money, again without ever actually having owned the asset. Needless to say, speculation is extremely risky and scrupulous brokers will only handle these transactions for sophisticated clients who thoroughly understand the risks involved.

Speculation in options is similar; traders who believe a security is increasing in price would buy calls, and those who believe it is falling would buy puts. There are a number of complicated strategies, given fancy names such as the "butterfly spread," the "straddle," etc., but they all serve the same purpose. Namely, to design a payoff structure such that the speculator makes money when the asset price moves in the proper direction. Should the asset fail to move in the desired direction, the option premiums paid are lost without the receipt of any physical goods.

It has long been debated among economists whether speculators are good for the market. Although some people still argue that speculation can be destabilizing, most agree that speculators are necessary participants in the market who help provide liquidity that hedgers need to trade.

CONCLUSION

Derivative securities markets play an important role by allowing investors who do not want the risks associated with holding an asset to transfer it to those who do. However, because they are markets for risk as opposed to physical assets, derivatives markets can be very dangerous places for unsophisticated investors. People who reduce their risk by entering a derivative market are called hedgers, and those who increase their risk are called speculators.

The derivative securities markets play a vital role in the modern financial systems, and without them many common business transactions would be rendered much riskier or practically impossible.