Derivative Instruments

Financial instruments that detach the price risks and rewards from assets so that these risks and rewards can be allocated to a party without regard to interests in the underlying asset. * Derivative instruments (or simply derivatives) are a category of financial instruments that includes options, futures, forwards and swaps. While there is general agreement among financial practitioners as to which instruments are considered derivatives and which are not, coming up with a general definition that conforms precisely to that understanding is difficult.

Innovation in the Financial Markets In policy and, too often, academic discourse, “innovation” carries a positive connotation. But the social implications of an innovation can be complex and often negative. Albert Einstein articulated the mathematics of physical relationships between mass and energy. But one practical application was nuclear weapons, and the consequences for the world have been mixed, to say the least. Similarly, the quantitative experts at the big banks have generated complex analyses of relationships among prices within and across asset classes: debt, equity, currencies and commodities.

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New financial instruments that are designed to reflect the relationships identified by the “quants” have proliferated. Innovation in the financial markets can be useful, but also harmful. As with Einstein’s work, some of the consequences of financial innovations are dangerous and volatile. Fundamental Characteristics of Derivatives The most significant financial innovations are tradable contracts that allow market participants to experience the financial consequences of rising or falling prices of asset classes without actually owning the assets.

These contracts synthesize the financial consequences of owning an interest in the asset. For example, instead of owning a barrel of oil, an investor can “own” changes in the price of oil, up or down, from a set date to the end of the contract term. These “financial products,” known as derivatives, are based on dynamic measurement of value over time. Their utility to investors is completely dependent on statistical forecasts of price movements based on historic observations. Derivatives Primer

Financial institutions have consistently described derivatives in language that is designed to make them appear benign to customers and regulators. Derivatives are characterized as “financial products,” as if they are they are commodities that have been produced for sale, rather than synthetic derivatives of actual products. More importantly, they are said to reduce risk. This facile description is constantly parroted by academics and policy makers. A new and more accurate description is badly needed.

All derivatives are swaps, but they may have different names based on the bells and whistles that are added, such as “futures” and “options. ” A swap is a contract to exchange one value for another, the value most often being the price of a security or other asset (the “referenced asset”). Swaps are structured on hundreds of different “prices,” including prices of equity shares, currencies, energy and agricultural commodities, precious and commercial metals and debt (in the form of interest rates or component of interest rates, like credit standing of the debtor).

Swaps on Forward Prices A forward price, as of any date, is the expected price of a referenced asset on a specified date in the future. For example, a simple oil price swap is based on a future delivery date and location and a quantity. The Effect of Derivatives on Capital Intermediation Efficiency In order to understand the affect that derivatives have on the capital intermediation system, we must identify how derivatives are used. It should be obvious that derivatives can be used to place a bet on a price move in lieu of buying an asset.

For example, a trader desiring to speculate on increasing oil prices could buy 100 barrels of oil and hold on to them. But he or she would have to pay for storage and transportation costs. Alternatively, the trader could enter in to an oil price derivative that increases and decreases in value as prices change. This kind of speculation through derivatives is commonplace in all of the derivatives markets. Traders at financial institutions speculate. But so do retirement funds and endowment funds of colleges and health care nstitutions. Each of these entities can adopt a strategy that seeks out the price risks and rewards of asset ownership and often uses derivatives to achieve this end. Derivatives as an Element of Capital Intermediation The capital intermediation function, the core social value afforded by the financial system, allows investment funds to be deployed to productive purposes. One element of this process is simply matching investors up with capital demand. But the needs of investors and consumers of capital are often not the same.

For instance, investors may want to lend at floating rates of interest while a borrower may want to have a fixed rate. A big part of the services provided by capital intermediaries is to reconcile these differences. Measuring Derivatives Effect on Capital Intermediation Inefficiency Overpricing directly affects the cost of capital intermediation. But that is only half of the analysis. The other side of the analysis is the value of the product that businesses and governments receive in exchange. As mentioned, credit capacity is finite.

The large disparity in the profitability of lending and derivatives credit extension means that businesses and governments will be prevented from tapping into capital lending sources or pay more for scarce capacity. It would be different if the credit extension were ten times more valuable to the company or government than a loan. However, the academic research suggests that this is not the case, especially when the research is read in the context of the practical use of derivatives in the marketplace.