Introduction
In the past two decades, we have witnessed phenomenal growth in the creation and use of various derivative instruments. This surge can largely be attributed to the increase in the volatility of interest rates, exchange rates, and commodity prices. Other contributing factors include financial deregulation, advances in information technology, and breakthroughs in financial engineering. Depending on the position taken, derivatives can:
- Act as a substitute for the underlying asset
- Offset an existing position in the underlying asset
- Enhance overall portfolio returns
- Hedge or reduce exposure to different sources of risk
What Are Derivatives?
Derivatives are not assets like stocks and bonds; their value is derived from an underlying asset, such as a financial security or a commodity. Institutional investors and portfolio managers utilize derivatives as sensible investments that can enhance returns and protect against inherent market risks. However, for many investors, particularly smaller retail investors, derivatives are considered risky and complex investments, a viewpoint attributed to the specialized nature of these instruments.
Certainly, the frenzied trading that the financial press often reports about oil and gas futures, foreign currencies, pork bellies, and gold sounds exciting. We have all heard stories about a commodity trader somewhere in the world betting the right way on a position in natural gas, for example, and making a fortune.
Versatility of Derivatives
Derivatives can be used in a variety of ways:
- Speculative Investments: High-risk, high-reward endeavors.
- Conservative Strategies: Used to conservatively hedge risk.
- Intermediary Strategies: A balanced approach between the extremes of speculation and conservatism.
This chapter focuses on the building blocks of derivatives. The key to understanding these products is to become comfortable with the terminology and understand:
- The contractual obligations being assumed
- The types of strategies employed
FAQs about Derivatives
Q: What is an underlying asset?
A: An underlying asset is the financial security or commodity from which a derivative’s value is derived, e.g., stocks, bonds, commodities, etc.
Q: Are derivatives suitable for all investors?
A: Due to their complex and risky nature, derivatives are typically more suitable for institutional investors and portfolio managers rather than smaller retail investors.
Q: How do derivatives help in risk management?
A: Derivatives can hedge against price movements in the underlying asset, minimizing exposure to different sources of risk.
Key Takeaways
- Multiply: Derivatives have grown phenomenally due to market volatility and technological advancements.
- Explain: They derive their value from an underlying asset.
- Contrast: They serve various functions, from speculation to conservative risk management.
- Understand: Knowledge of terminology and strategies is crucial for leveraging derivatives.
Glossary
Derivative: A financial instrument whose value is based on the performance of an underlying asset.
Underlying Asset: The asset from which a derivative derives its value.
Hedging: A risk management strategy used to offset potential losses.
Speculation: The act of trading in an asset, or conducting a financial transaction, that has a significant risk of losing value but also holds the expectation of a significant gain.
Financial Engineering: The application of mathematical methods to solve financial problems.
This section sets the stage for detailed exploration of derivative instruments, providing readers with a solid foundational understanding necessary for navigating more complex topics in subsequent chapters.
📚✨ Quiz Time! ✨📚
## What is a primary reason for the growth of derivative instruments in the past two decades?
- [ ] Decreased volatility in interest rates and exchange rates
- [x] Increased volatility in interest rates, exchange rates, and commodity prices
- [ ] Reduced advances in information technology
- [ ] Financial regulation
> **Explanation:** The primary reason for the growth of derivative instruments is the increased volatility in interest rates, exchange rates, and commodity prices, which made derivatives essential for hedging and managing these risks.
## What is the main characteristic of a derivative?
- [x] Its value is derived from an underlying asset
- [ ] It is a physical commodity like oil or gold
- [ ] It does not involve legal contracts
- [ ] It is not influenced by financial markets
> **Explanation:** A derivative’s value is derived from an underlying asset such as financial securities or commodities.
## Who primarily relies on derivatives for enhancing returns and protecting against market risks?
- [ ] Small retail investors
- [x] Institutional investors and portfolio managers
- [ ] Independent day traders
- [ ] Government regulators
> **Explanation:** Institutional investors and portfolio managers rely on derivatives to enhance returns and protect against market risks.
## Why are derivatives considered complex and risky by many smaller retail investors?
- [ ] Because they are easy to understand and involve less legal complexity
- [ ] Because they are heavily regulated by the government
- [x] Because they are specialized financial instruments created by market participants
- [ ] Because they are not influenced by market conditions
> **Explanation:** Derivatives are considered complex and risky because they are specialized financial instruments that require understanding of market conditions and legal complexities.
## What impact have advances in information technology had on derivatives?
- [ ] Decreased their usage
- [ ] Made them less complex
- [x] Contributed to their growth
- [ ] Removed the need for market participation
> **Explanation:** Advances in information technology have significantly contributed to the growth of derivative instruments by enabling complex calculations and real-time market data analysis.
## How can derivatives be used in investment strategies?
- [ ] Only as conservative investment vehicles
- [x] As wildly speculative or rigorously conservative investment vehicles
- [ ] Only as speculative tools
- [ ] Only to replace underlying assets
> **Explanation:** Derivatives can be used both as speculative and conservative investment vehicles, depending on the strategy pursued.
## What is an essential aspect to understand when dealing with derivatives?
- [ ] The physical properties of the commodity
- [x] The terminology and contractual obligations
- [ ] The weather conditions affecting the assets
- [ ] The country of origin of the underlying asset
> **Explanation:** Understanding the terminology and contractual obligations is essential when dealing with derivatives to grasp their functioning and the types of strategies being pursued.
## Which of the following is NOT commonly considered an underlying asset for derivatives?
- [ ] Financial securities like stocks and bonds
- [x] Real estate properties
- [ ] Commodities like oil and gold
- [ ] Foreign currencies
> **Explanation:** Real estate properties are not commonly considered underlying assets for derivatives as they usually pertain to financial securities, commodities, and foreign currencies.
## Which development has NOT contributed to the growth of derivatives?
- [ ] Increased volatility of financial markets
- [x] Increased market regulation
- [ ] Advances in financial engineering
- [ ] Financial deregulation
> **Explanation:** Increased market regulation has not contributed to the growth of derivatives; rather, it is financial deregulation that has played a role.
## What should an investor understand to use derivatives effectively?
- [ ] The behavior of the physical commodity market
- [ ] The latest technological gadgets
- [x] The types of strategies and contractual obligations
- [ ] Government policies on asset tracking
> **Explanation:** To effectively use derivatives, an investor must understand the types of strategies and the contractual obligations involved.