Derivatives 101: The devil’s in the details

Are derivatives “risky” assets that set off the financial crisis of 2008? Or are they a way to reduce or “hedge” investment risk?

HiResThere’s no easy answer to that question, because it depends on how they’re used. Rather than treat all derivatives with a broad brush, it’s important to understand the nuances.  

The following outlines a recent NICSA-hosted webinar featuring Philip Sindel of Olmstead Associates, who explained the “devil” in the details of derivatives.

What’s a derivative?

A derivative is a security that derives its value from that of an underlying security or asset. The main types of derivatives are futures, options, and swaps. One major distinction is whether a security is exchange-traded or traded over-the-counter (OTC).

Exchange-traded derivatives are standardized and the presence of an exchange in the middle helps guarantee that contractual obligations will be met. Because there is no middleman for OTC derivatives, these are riskier. OTC derivatives introduce counterparty risk, or the risk that the person or entity on the other end of the deal may not hold up their side of the bargain.

What are the key terms of a derivatives contract?

Futures contracts give an investor the obligation to buy or sell an asset. Key terms are: 1) exact price and 2) specific date in the future when the transaction will take place.

Options contracts give an investor the right, but not the obligation, to buy or sell a certain asset at a certain price. Key terms are: 1) exercise or “strike” price, 2) expiration date, and 3) underlying quantity that can be bought or sold.

Swaps contracts typically involve the negotiated exchange of predefined asset cash flows. Key terms are: 1) size or notional amount of the contract, 2) length of contract, 3) re-set date, and 4) collateral, if it is an OTC contract.

What trends are happening with derivatives today?

Derivatives are seeing increased use as alternative investment products increase in popularity. Investors in these products typically are seeking to diversify portfolios of traditional investments to hedge risk and improve returns.

Management of products using derivatives is moving from boutique managers to traditional institutional money managers who want to provide more attractive products to clients.

Regulators are seeking to make derivatives safer and more transparent by better defining rules around their use. Here are some proposed changes:

  • Increased use of clearinghouses, such as the Options Clearing Corporation, which guarantee the obligations of counterparties.
  • More defined rules for collateral: How much? What type?
  • Legal entity identifiers (LEIs) for all counterparties to ensure no single entity is overexposed.
  • Increased capitalization requirements for big derivatives contracts.

The estimated value of the OTC derivatives market is now about $700 trillion. This marketplace continues to grow due to ongoing innovation in alternative products and strategies. That’s why it’s important for industry participants to understand the details of derivatives.

Learn more about the derivatives and their various types and trends,  be sure to view, and listen, to the Foundations in Derivatives webinar archive.

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