Derivative assets are those assets whose value is derived from some other assets. Futures & options are two main categories of best known derivative assets. Other derivative assets include swaptions, swaps and inverse floaters, each of these have different risk features. Plain vanilla derivative assets are mostly useful to mutual funds, pension funds, corporate treasurers, endowments and financial institutions. Not all derivative assets are similar; some are highly conservative while some are inherently speculative.
The rationale for Derivative Assets
The Chicago Board of Trade was probably the first organized derivative exchange in the United States. The main aim of this derivative exchange was to keep stability in the agricultural prices. It is easy to understand the problem of farmers. At the same time, everyone’s wheat was harvested. The principles of economics applied to the market when all these quantities of wheat arrived in the market. As there was abundance of supply in the market so the prices fell sharply and the farmers are compelled to sell their products at the prevailing price. At later winter season, the prices again increased due to increase in demand and decrease in supply. The future market is helpful for farmers in eliminating the price risk for their crops. Similar function is served in current years by the derivative assets. The farmers using futures made promise to provide their crops at some future time at a certain price. Hence the market stability was promoted and anxiety of the farmers was reduced. In a similar way, the derivatives are used by the financial managers to eliminate the price risk of their bonds, stocks and foreign currency portfolios etc.
Derivative Assets and the News on Current Events
There are real life reports in newspapers about many companies which have suffered loss in billions by investing in derivative assets like Proctor & Gamble, Orange County etc. Many individuals call their brokerage firms to ask about any derivative in their accounts. In investment business, it is perennial problem to educate the users. It is not clear to most of people that stocks pay dividends instead of interest. Furthermore certain terms like calls, puts, futures and other derivates is also difficult to understand by common individuals. In case of derivative assets related to bonds, many investors are not capable of making good decisions.
Risk of Derivative Assets
The main aspect of derivative assets is that they are neutral products. The options and futures are not inherently risky, inappropriate or dangerous. What an investor does with these assets, can make them risky. Some people consider derivative assets risky.
Listed Vs Over-The-Counter Derivatives
There are certain derivative assets that are exchange-traded assets while some of them are traded over the counter market. For example, an APR is a listed option that calls from the Chicago Board of Exchange. It is guaranteed by the Options Clear Corporations and has standardized characteristics therefore it is fungible and can be traded quickly on desire. Many other derivative assets are traded over-the-counter market and hence are considered as over-the-counter derivatives. A large multinational company can contact with many money centre banks and ask for designing of product that is protected from the interest rate risk, market risk and foreign exchange rate risk. Every bank will have desire to perform the job and everyone have information that the other institutions are bidding on the job.
Examples of Derivative Assets
Following are the main examples of derivative assets.
Future contract is an agreement between two parties that specifies the provision of certain product (financial or tangible) at a certain future date and at a specified price. There is buyer and seller for each contract. Credit risk is involved in future contract which means that any of the part can default on its obligations. Besides this liquidity risk is also linked with this contract.
Option is a contract which gives the right to the owner for buying or selling the underlying asset. There are two parties involved option, one buy while other sells that option.
Uses of Derivative Assets:
Derivative assets are quite popular and have the following uses.
- Risk Management
- Risk Transfer
- Financial Leverage
- Income Generation
- Financial Engineering