Derivatives

What Is A Derivative?

Derivatives are financial instruments that derive their value from an underlying asset such as a currency, a commodity like oil, gold or wheat, stocks and bonds, or interest rates. The most common types of derivatives are options and futures, credit default swaps, interest rate swaps and collateralized debt obligations (CDOs).

Pros of Derivatives

Derivatives were originally developed to enable companies and producers to protect themselves against wide price changes before they could bring their product to market.

For example, a farmer may buy a futures contract to lock in the price of wheat to hedge against the possibility of the market price falling before the crop is harvested and brought to market. Likewise, a multinational company may buy a derivatives contract to protect itself against swings in foreign currencies or interest rates.

Speculation Tool

More commonly, hedge funds and other professional investors use derivatives to speculate on the value of the underlying assets without actually having to buy or take delivery of the actual asset when the contract expires. Derivatives also enable these investors to use leverage to increase the size of their bets at a relatively low cost.

Cons of Derivatives

While derivatives provide several benefits, such as those mentioned above, they also carry some pitfalls, many of which were exposed in the runup to the financial crisis of 2008.

For example, credit default swaps (CDS) enable investors to hedge against the possibility of a bond issuer defaulting on its obligation to pay principal and interest. A CDS acts as bond insurance, with the investor swapping the default risk with an insurance company, a bank or a hedge fund, in exchange for a premium.

Prior to the crisis, several insurance companies, including American International Group (AIG), sold CDSs against a bond default by Lehman Brothers. When Lehman failed in September 2008, burdened by a large portfolio of subprime mortgages and other high-risk securities, AIG was unable to make good on the CDSs it had written, nearly failing along with Lehman before it was bailed out by the U.S. government.^[1]

This episode shows some of the dangers of derivatives. In the Lehman-AIG case, the presence of CDSs may have given bond investors a false sense of security, inviting them to take on more risk in the belief that their investments were insured. However, neither the extent of Lehman's problems or AIG's guarantees were known before the collapse.

Complexity

The opaque and often complex nature of many derivatives also makes them risky. Prior to the crisis, many Wall Street firms bundled a variety of financial assets, including residential mortgage and automobile, loans into CDOs in which the true riskiness of the underlying loans was not properly disclosed to investors.

Difficult to Predict Pricing

This illustrates another problem with derivatives, namely that it is often difficult to accurately price them. Many CDOs were backed by hundreds if not thousands of individual loans, many of which were poorly underwritten or were made to high-risk borrowers, without the proper disclosure to investors.

Leverage

The leveraged nature of derivatives, which is one of their advantages, is also one of their biggest shortcomings, since losses can be magnified if the price of the underlying asset moves in the direction opposite to what the trader is betting on. As a result, trading in many types of derivatives is often very volatile.

Use in Scams

This leads to another disadvantage of derivatives, namely that they are often used by fraudsters to dupe unsuspecting investors into scams. Most derivatives are traded over the counter, although some are traded at a financial exchange. The largest such exchange is the one operated by CME Group, which trades derivatives on all types of assets.

Regulation

In the U.S., the derivatives market is regulated by the Commodity Futures Trading Commission, an independent agency of the federal government. In the wake of the financial crisis and the collapse of Lehman and the near-failure of AIG, the agency was given additional oversight over the swaps market, which had been unregulated before the crisis, by the Dodd-Frank Wall Street Reform and Consumer Protection Act.^[1]

Summary

Derivatives are financial instruments that derive their value from an underlying asset, such as a currency, a commodity, stocks and bonds, or interest rates. Although derivatives were originally created to enable companies and traders to lower their risk by protecting themselves against future price changes, derivatives are often very risky and highly volatile because of their often opaque nature and high leverage ratios.