The Need for Derivatives

In the previous article, we discussed as to how derivatives contracts can be dangerous and can pose a systemic risk. Then the question arises as to why are derivates needed at all? If they are dangerous financial instruments, that can pose a risk to the safety of the entire financial universe, then why is it that we use derivatives at all!

The truth is that derivatives were created out of the need of financial markets. They can and do serve a wide variety of purposes and that is the reason that they exist. Some of the purposes that they serve are ethical whereas others are not. In this article we will list down the 4 most common reasons behind the usage of derivatives.

Purpose #1: To Hedge

Derivatives were originally created as tools for hedging. Businesses face a lot of risks related to commodity prices in their day to day operations.

• For instance, the operations of an airline firm are largely affected by the prices of jet fuel. The prices of jet fuel fluctuate on a daily basis. Hence, businesses cannot earn a stable income. Organizations usually prefer stability and hence there is a need for a financial instrument which can ensure stable prices regardless of the rise and fall in commodity prices

• Exporters face a lot of risk related to foreign exchange. Their goods are invoiced in foreign currency. However, they have to pay their expenses in local currency. The exchange rates between the foreign and local currency change every second. Hence, the profitability of such an export oriented firm is hit by these changes in the commodity prices. They too feel that there is a need for a financial instrument which can provide them a stable exchange rate regardless of the ups and downs in the market so that they can plan their operations based on this stable platform.

• Lastly, a farmer faces the risk of the variability in the price of his produce. If there is excess produce in a given year, then the prices are low or else the prices are high. The farmer wants to get rid of this price variability and hence feels that there is a need for a financial instrument that can help him fix the prices.

Hedging is the legitimate reason for the existence of derivatives. Hedging happens when the people buying or selling derivatives contract use the underlying asset in the day to day operations of their firm.

Purpose #2: To Speculate

The second most common reason behind the usage of derivatives is speculation. Now, this may not seem like a legitimate reason. However, speculators are necessary participants in any market as they provide liquidity.

Hedging happens when the parties to a contract have genuine business interests in the underlying asset. Speculation is the exact opposite. Speculators have no interest in the underlying asset and take part in the contract because they believe that they can make a gain out of the price movements. For instance if you believe that the US dollar will depreciate significantly against the Euro in the next month, derivatives contracts enable you to take a position on this in the market. Since derivative contracts are extremely leveraged, speculation in the derivative market is a highly risky business. However, there are people who specialize in doing so.

Purpose #3: Circumventing Regulations

The third reason why derivatives are used in the marketplace is to circumvent regulation. Certain institutions like pension funds are prohibited from making investments in any kind of risky securities. Hence, derivatives help in superficially de-risking the securities and making it legal for the pension funds to purchase them.

Consider the case of mortgage backed securities. Pension funds were not allowed to invest money in real estate since it was considered a risky bet. However, investment bankers created de-risked mortgage backed securities which were backed by agencies like Freddie Mac and Fannie Mae. These securities appeared to be risk free and hence pension funds could legally trade in them.

There are many such instances wherein derivatives have been used to circumvent regulations and change the very nature of the investment being made.

Purpose #4: Minimizing Trade Costs

Investors all over the world do not like transaction costs. Derivatives provide a great way to avoid and evade them. This can be best explained with the help of an example.

Consider the case of a company that has taken a fixed rate loan from a bank. However, now they believe that the interest rates will go down. Hence, they feel like they should take a floating rate loan. However, closing the loan before its due date would attract prepayment penalty. Also, taking a new loan would generally attract processing charges. Hence to avoid these transaction costs on both sides, a firm can simply structure a swap wherein they can switch over to floating interest rates without bearing any of the above mentioned transaction charges.

Hence, derivatives are extremely useful financial instruments. This usefulness adds tremendously to their popularity and explains why ever Multinational Corporation, major bank or investment bank in the world is highly involved in derivative trading.