Derivatives: hedging or creating risks?

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Derivatives represent securities whose value relies upon an underlying asset or a group of assets, which represent the derivative’s benchmark. In essence, a derivate is a contract between two parties which establishes the payment conditions for a future established date, which is called maturity. Derivatives inherit their values from the value fluctuations of its underlying asset.

The gross market value of derivatives was estimated at $11.6 trillion at the end of 2019. In June 2020, the market value surged to $15.5 trillion, with around 33 per cent increase. Most of the time, people use them for commodities such as oil or gold, or currencies, usually the US dollar. Furthermore, there are also derivates emerging from stocks and bonds.

Investors use derivates to hedge risk and avoid financial losses. For example, derivatives are commonly used to hedge the interest rate risk Derivatives are utilized as speculation tools for future price trends of an asset, as investors seek protection from the price fluctuations within the market. The main rationale on which buyers enter them is that the price will grow and they seek to reap off the benefits of buying them at the current price. Conversely, the sellers predict that the price will fall and they seek to sell them at the bigger present value.

There are various types of derivates: forwards, futures, options and swaps.

Futures are standardized contracts which enable the contract’s holder to either buy or sell the respective underlying asset at an agreed price on a specific date.

Forwards are quite similar to futures, however, they impose more flexible contracts as the involved parties can modify both the underlying asset, the quantity of the commodity and the maturity of the transaction In order to make future transactions, brokers and traders must be registered with the National Futures Association(NFA) and the Commodity Futures Trading Commission (CFTC).

Options are quite similar to futures, however, there is a key difference: one party does not have to abide by their agreement to buy or sell. Hence, the buyer has the right, not the obligation, to but the asset. It can exercise this right either on the agreed date (usually in the European area) or anytime before the maturity (in the USA). There are two types of options: a call option, which enables the holder the right to buy the asset, versus put option, which the holder to sell the asset

Swaps are exchanges of pre-agreed cash flows associated with two distinct assets of each party. It is the most complicated derivate, as it covers two agreements rather than just one. For investors, a swap represents a path for accessing new markets which are otherwise restricted by disadvantageous exchange rates.

Another benefit of derivatives is the possibility to avoid taxes because they can provide the investor with a continuous income source, on which the individual may not be obliged to pay the capital gains tax.

However, derivatives have several drawbacks which should be taken into account. First, they are sensitive to market variables of supply & demand. Some argue that these investments pose a high risk. Besides, it very difficult to know the real value of the derivative and might contribute to the market volatility, exposing investors to high risk. Warren Buffet describes derivatives as “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

Experts consider that derivatives, specifically mortgage-backed securities, were a huge destructive factor in the aftermath of the worldwide financial crisis in ‘07 and ’08. Therefore, considering these hindering aspects, derivates are not a suitable option for beginner investors.

Derivatives represent a weapon for both the risk-averse and risk-seekers. Nonetheless, this type of investment requires some experience as it is hard for beginners to successfully manage them.

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