Derivatives as a Risk Mitigation Tool
If carrying risk is too high, some securities holders will use derivatives to minimize the risk. Carrying risk is the risk associated with storing a physical commodity or holding a financial instrument over a length of time. A derivative is a contract allowing for the transfer of an underlying asset without actually transferring the asset. An underlying asset is defined as the object by which the derivative's value is determined. Typical underlying assets include commodities, stocks, currencies, interest rates, and bonds. Owning a derivative does not always come with ownership of the underlying asset, depending on the type of derivative. Derivatives are traded on two platforms: on an exchange or over the counter. "Over the counter" refers to trading on any platform other than an exchange. The trading platform is dependent on the type of derivative. For example, if Mary wants to purchase derivative contracts, she would go directly to a bank that offers them, the Federal Reserve Bank of New York being one of the largest offerers.
Derivatives traded on an exchange are regulated. This gives the derivative a certain level of standardization. The standardization of derivatives traded on exchanges provides a level of liquidity, which is the ability to convert assets to cash with ease, that is not found in derivatives sold over the counter. This liquidity makes these derivatives more practical for use in hedging strategies. Over-the-counter derivatives are unstandardized, customizable, and unregulated. This gives over-the-counter derivatives a greater level of risk. However, the majority of derivatives are traded over the counter.
The original purpose of derivative securities was to account for differences in the value of currency for the commerce of internationally traded goods. Now, common uses for derivatives include speculating and hedging. Speculating is a financial action that carries a risk of total loss of value but has the prospect of large gains that offset the risk of loss. Speculation often takes the form of purchasing an asset with the hope of the asset's value increasing in the near future. Often, speculation is hunch based rather than analysis based. For example, Larry has observed the price of Super Center's stock rapidly increase over the last several months. Larry anticipates that Super Center's stock will continue to increase at the same rate. Larry purchases shares of Super Center with the intent of holding the shares for a short period and then selling them after they have increased in value. Larry's actions are purely speculative. He has not applied any research or analysis. His actions carry a high amount of risk for loss but also substantial gain if his hunch is correct.
Part of the risk associated with derivative trading is in value uncertainty. Because the value of a derivative is based on an underlying asset, the real value of a derivative is never certain.
Common Derivatives and Alternative Investments
There are multiple types of derivatives, each with its own benefits. The most common derivatives are in the form of futures contracts, forward contracts, swaps, and options. Futures contracts are agreements made between two groups to buy or sell an asset at a previously agreed-upon price at a particular time in the future. The seller has an obligation to deliver the underlying asset upon the expiration of the futures contract, and the buyer is obligated to purchase the underlying asset upon expiration of the futures contract. Futures contracts are regulated and traded on a futures exchange.
Forward contracts, like futures contracts, are agreements made between two groups to buy or sell an asset at a previously agreed-upon price at a particular time in the future. Similar to futures contracts, the seller has an obligation to deliver the underlying asset upon the expiration of the forward contract, and the buyer is obligated to purchase the underlying asset upon expiration of the forward contract. The difference between forward contracts and futures contracts is in how the contracts are traded and regulated. Futures contracts are traded on exchanges and are regulated by the U.S. Commodity Futures Trading Commission (CFTC). Forward contracts are customizable private agreements traded over the counter and are not subject to the same CFTC regulations.
Like forward contracts, swaps are also derivatives with their own benefits. A swap is an agreement to trade financial instruments; often included as terms of a loan. Often, swaps are used to change a loan from a fixed interest rate to a variable rate or vice versa. Swaps are not available on an exchange and are traded over the counter. Swap agreements are typically completed between businesses and financial organizations.
Derivatives are versatile financial instruments with unique terminology. An option is a derivative with a contract that allows, but does not obligate, the purchase or sale of an asset. The strike price is the value at which a call or put option may be implemented until the expiration date. A call option is an agreement that allows the buyer to purchase an underlying asset at the strike price before contract expiration. The buyer is not obligated to complete the transaction, hence the name of the derivative: option. A buyer pays the seller a premium for an option. The premium is when a stock has been sold for a price that is more than its par value. The seller is not obligated to complete the transaction, because it is an option. For example, if Mary Nelson wants to buy an option for $10 per share to purchase a contract for stock at $125 per share, she would call an option at $10 for a strike price of $125.
A collateralized debt obligation is a type of derivative in which the value is centered on the agreement to repay debt. The debt is made up of consumer credit card debt, auto loan debt, and mortgages bundled into a security. Collateralized debt obligation derivatives triggered the financial crisis of 2007 and 2008. This financial crisis was considered by many experts to be the most severe since the Great Depression. The crisis was triggered by the high rate of default on subprime mortgage securities that had been marketed as having low risk. This event cascaded to the banking sector, resulting in the failure of many banks. The financial crisis was believed to have threatened the integrity of the global financial system.