A risk averse investor can buy, for example, an item now at its spot price and wants to eliminate the risk, at least partially, that the price of the item may fall. To eliminate this risk he or she can sell a forward contract for the same item or some other good with good price correlation with the initial one that will offset part of the risk, thus hedging his investment against a price fall.
Derivative instruments provide great leverage for speculators who can amplify the financial consequences of their trades, enabling them to increase their gains if they have the right predictions or increase their otherwise.
Derivative markets provide more liquidity than spot markets because high-volume trades can be easily accommodated using leverage.
In this way derivatives enable the transfer of risk from investors who want to reduce their risk, to speculators who wish to increase it.
The volume of transactions in derivatives markets increased dramatically in the last 30 years, reaching $613.1 trillion in 2007 (Hull, 2009). With the prices of financial products changing rapidly it is not always possible to ensure that prices are consistent over all markets. Arbitrageurs take advantages of the differences in prices between two or more markets. They engage in opposite sides of the same trade in different markets, being long in one market and short in the other one to lock in a riskless profit. The existence of arbitrageurs ensures market efficiency and accurate prices because opportunities for arbitrage are few and last for very short periods of time.
Arbitrage also ensures the linkage between spot and derivatives markets by eliminating the disparities in prices between the two.
A positive externality of derivative markets is its price discovery function. Prices quoted for various contracts refer to the standardised product that is assumed to be homogeneous, even if the underlying market is large and fragmented. Nevertheless they offer an accurate prediction of what the price of the commodity or stock is expected to be in the future. Another benefit of derivatives is the provision of a “complete market in which any and all identifiable payoffs can be obtained by trading the securities available in the market.“ (Kolb, 2007, pg.7)
When the stock exchange doesn’t allow the possibility for short selling a stock, a derivative can be used to replace the shorting of a stock. Derivatives can be applied for speculating on the outcome of certain events like weather or start of a war, because stock markets don’t allow exposure to this kind of changes. (Hamisultane, 2010, pg. 503)
The overall benefit to the economy is significant because investors who can hedge their risk as they wish will provide more funds to the financial markets, which consequently will enable more firms to raise capital while keeping the cost of the capital at its minimum.
The high liquidity and volume of transactions in the derivative markets attract a large number of participants which brings the benefits of economies of scale by reducing the transaction costs for the market makers and increases the market efficiency by attracting arbitrageurs.
2. What risks are involved in trading derivatives and who bears these risks?
Despite the fact that trading in derivatives is often used to reduce risk, there are some risks involved that investors and dealers need to take into account when using derivatives.
Derivatives traded in on exchanges have their delivery guaranteed by the exchange. In this way the default risk is transferred from the contracting parties and making the dealer who issued the derivative subject to the risk of default.
The market maker ensures that demand for derivative contracts meets the supply by adjusting their prices. In some exceptional situations, when one side of the market is absent, the market maker has to either replace it and assume its risk, or shut down the market for a short period. This can be caused by a stock market crash or panic among traders.
In the over the counter transactions, both parties are subject to the risk of default. Even though only sophisticated investors and institutions are allowed to engage in the over the counter trading the credit risk is still present. It is usually the more credit worthy party that is in a more risky position, but there is a chance of it defaulting as well. On some occasions the less credit worthy party is asked to provide a guarantee in a form of a deposit to compensate for the risk it brings to the contract. Credit scores are used as a risk management tool to rate companies and institutions by their probability of default.
Hedgers use derivatives to minimise their exposure to the changes caused by fluctuating exchange and interest rates, stock and commodity prices, while speculators, on the other hand, increase their exposure to market risk.
Operational risks are relevant to the discussion of derivatives because while dealing with large volumes and using leverage, a small error can have disastrous consequences. In the case of the derivatives traded on an exchange, it is the party who is issuing or creating the contract that is subject to the miscalculating risk. That is because the frequently changing market conditions, prices on foreign exchanges and other factors make it more difficult for dealers to create accurate contracts. These miscalculations may result in losses because of arbitrageurs who seek to profit from such mistakes.
The miscalculation risk is relevant for the over the counter transactions as well because each party has to calculate accurately how much will it have to charge or pay for the hedge. The contracting parties in this case may have less experience in creating the derivative contracts than dealers and therefore are more prone to errors.
Traders dealing in small volumes are subject to the risk of over hedging and under hedging because most market contracts are dealt in specific numbers of shares, barrels, tons, which makes it difficult at times to find the “perfect hedge”(Investopedia, 2010) and therefore the trader may be subject to the risk of over hedging, which means that he is taking more risk than he or she initially intended.
In large financial institutions the administration of derivatives trading can get very complex. In trying to avoid fatal mistakes the company has to devise ways to monitor, control and check dealers and traders who are dealing with large sums because everybody can make mistakes. Besides making unintentional mistakes, the risk of fraud is worth considering too. For example, Nick Leeson of Barings Bank who was supposed to hedge and arbitrage on the Singapore Monetary Exchange on behalf of the London bank, started speculating, what resulted in losses of over one billion dollars.(
Losses of this magnitude can cause shocks in the financial markets worldwide. This is why regulatory bodies require institutions to keep some money aside to offset potential losses.
The changes in this kind of regulations can become another risk for the market participants because a change in regulations can affect the plans for a long term investment.
Bibliography
Chance, D.M. (1989), An Introduction to Derivatives and Risk Management, 5th ed., Orlando, Florida: Harcourt College Publishers.
Chance, D.M., Brooks, R., (2008), An Introduction to Derivatives and Risk Management, 7th ed., Mason, Ohio: Thomson South-Western.
References
British Broadcasting Corporation, (2003), Derivatives - a simple guide [online]. Available at: http://news.bbc.co.uk/1/hi/business/2190776.stm [Accessed 25 November 2010]
Dubofsky, D.A., Miller, T.W., (2003), Derivatives: Valuation and Risk Management, Oxford: Oxford University Press.
Hamisultane, H., (2010), ‘Utility-based pricing of weather derivatives’, European Journal of Finance, Vol. 16 Issue 6, 503-525.
Hull, J.C., (2009), Options, Futures, and other Derivatives, 7th ed., New Jersey: Prentice Hall.
Investopedia ULC, (2010), Dictionary [online]. Available at: http://www.investopedia.com/terms/p/perfecthedge.asp [Accessed 23 November 2010].
Kolb, R.W., Overdahl, J.A., (2007), Futures, Options and Swap, 5th ed., Carlton, Australia: Blackwell Publishing.
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