Futures, options, swaps… the explosive development offinancial engineering over the last forty years it has been such that a complete taxonomy of the universe of “derivatives” would require an encyclopedic effort. Also because the boundary between "derivative" instruments and "traditional" instruments has disappeared over time: come on old convertible bonds up to banking subordinates, more or less explicit derivatives have been injected into traditional instruments creating increasingly complex forms of financial hybridization.
Derivatives: how are they classified?
At a very general level, derivatives are classified based on three dimensions: the type of underlying financial variable (therefore, exchange rate derivatives, rate derivatives, equity derivatives...), the exchange market (regulated markets, especially for futures or call and put options on individual shares, or unregulated markets where transactions are bilateral) and the “linearity” of the pay-off function. For example, futures are "linear", while options are not (see the figure).
Remaining on a level of maximum generality, i futures are contracts in which the two parties undertake to buy (the so-called "long" part) and sell (the "short" part), at a future date and at a predetermined price, a certain quantity of the underlying asset (commodities, stock indices, government bonds…). If on the future date the price of the underlying is higher than the established one, the long party gains and the short party loses. And vice versa, if the price of the underlying is lower. There is no right to withdraw from the contract for either party, unless they find some other operator willing to take over. In other words, it is about “forward” trading operations, which differ from the "spot" ones for the sole fact of deferring the delivery of the underlying over time. Their use is therefore of coverage, But also investment or speculation. An airline that does not want to run the risk that the revenue from travel tickets sold today will not cover the cost of fuel when it has to transport passengers in August can hedge the risk of price increases by buying a oil futures today, with delivery in September (the typical date of the quarterly futures cycle). Likewise, an investor who wants diversify your portfolio by buying gold, you can purchase a fund that, in turn, invests in gold futures, gaining full exposure to gold price movements without having to bear the enormous costs of managing “physical” gold.
In the case of optionsUnlike futures, one party has the right but not the obligation to exercise the option. In a call option, the buyer has the right but not the obligation to buy at the set price. Therefore, if the final price of the underlying is lower than the established price (also called strike price), the call option is not exercised. In a put option the opposite happens: the buyer has the right but not the obligation to sell at the pre-established price. Therefore, if the price were to be higher than strike, the put is not exercised. Obviously, in exchange for this right, the buyer will have to pay, at the time of signing the contract, a seller reward. Even with options the objective can be both hedging and speculative. If, for example, you fear that Wall Street may undergo a strong correction, you can purchase a put option on the S&P500 index. In this way, your portfolio is immunized, in whole or in part, from the risk of collapses and the premium paid is equivalent to a sort of insurance premium. If, however, you want to have exposure to possible increases, but you do not have the necessary capital available to do so and you want to limit the potential loss to the premium paid, you can purchase a call option.
- swap they are relatively more complex because they involve the exchange of two future cash flows, at least one of which is uncertain, at a series of pre-established dates. The typical example is that of a fixed-variable swap. If you want to transform a variable rate mortgage (10 year, for example) into a fixed rate mortgage (also 10 year), you can enter into a swap in which you receive from the counterparty, on the payment dates of the installment of the mortgage, the variable rate prevailing from time to time and in exchange a fixed rate is paid to the counterparty (equal to the 10-year "swap" rate prevailing on the market on the date of stipulation of the swap contract).
Moving from the general level to that of market practices, it must be underlined that there are countless sub-categories to distinguish the “exotic” derivatives from those "Normal", derivatives whose pay-off is path-dependent (that is, it depends on the performance of the underlying during the entire duration of the contract) from those whose pay-off is instead determined by the value of the underlying at maturity, and so on. The complexity is such that only for a minority of derivatives there are closed formulas for evaluating their price (the famous Black-Scholes equation and its numerous variants), while for the rest "Monte Carlo" simulations are used. That is, thousands of possible alternative scenarios for the performance of the underlying are simulated and, based on the results obtained, the value of the derivative today is deduced.
Derivatives, here are some practical examples
But beyond the computational complexity of the valuation problem, the important thing to understand is that derivatives with non-linear pay-offs require assigning a price to a new variable: the volatility of the underlying. In fact, a change in volatility affects the two parties involved in an asymmetrical manner. To give an example, consider the call option illustrated in Figure 1 and let's suppose that the price of the underlying could be equal to either 120 euros (50% probability) or 80 euros (50%) at maturity. The value of the call in this case would be equal to 10 euros, i.e. 20 euros multiplied by 50% (in fact, if the price of the underlying is equal to 80, the call would not be exercised). If the volatility is higher and the underlying at expiry can be equal to 130 or 70, the value of the call becomes 15 euros. In the case of a futures, however, given that the effect is symmetrical on both counterparties, the price is indifferent to variations in volatility.
This difference gave birth to a whole new series of financial instruments and indicators, which deduce the degree of uncertainty perceived by the market from the price of options. The famous VIX, journalistically often called fear index, is nothing more than a measurement of volatility used from time to time by market operators to evaluate options on the S&P500 index.
On the other hand, derivatives arise from the need to manage the risk inherent in the temporal mismatch that may exist between one's "assets" and "liabilities". THE futures on agricultural commodities they were created at the end of the 800th century precisely to allow producers to manage the risk of excessive price variations between the time of sowing and harvesting. The foreign exchange swaps they were born in the wake of the monetary chaos caused by the end of Bretton Woods to manage the risk posed by the general adoption of a flexible exchange rate regime. The same credit derivatives, despite the terrible reputation gained in the great crisis of 2008, were created to respond to a motivated need for more modern and flexible forms of management of the default risk imposed by the then nascent phenomenon of banking disintermediation in the financing for the economy.
From the beginning, economic theory understood that a derivatives market also needs the “speculative” component. If there were no operators who buy and sell derivatives for the sole purpose of earning from price movements or to arbitrage deviations between derivative markets and underlying markets, there would not be a sufficient degree of liquidity to be able to carry out their primary function, which is precisely that to support "real" operators in risk management. But just as quickly, the danger for the individual operator and for the market as a whole of excessive use of derivatives for speculative purposes was understood.
Derivatives, what is the “insurance” characteristic of the minimum cost
We have, in fact, omitted another characteristic of derivatives, which is of fundamental importance for them to be able to carry out their primary function of hedging risks. The principle according to which derivatives are structured and valued is in fact what we could define “insurance” of the minimum cost. If one of the parties has a contractually established right which, based on the probabilistic development of events, leads to a positive expected benefit, the other party will receive a corresponding reward. This happens in options, as we have seen in the simple examples above, where the party who has the right, but not the obligation, to exercise finds himself in an advantageous situation and must therefore pay the counterparty a premium equal to the advantage expected. The use of the term prize it is not random: it is exactly what happens in a car insurance contract, where the car owner pays the insurance company a sum of money that depends on the probability of suffering damage and the presumed cost of repairing the damage.
In the case of derivatives where none of the counterparties has a contractually pre-established advantage, this is pure betting and the premium is zero. Then, based on the subsequent evolution of events, we will see who wins or who loses. This is the case of futures or swaps, where the only initial payment is the so-called "margin", a sum deposited to guarantee the solvency of the commitments implicitly assumed by both parties and which changes during the duration of the contract based on to the losses or gains implicit in the evolution of the underlying variable. The term margin call, the title of a recent film on the great crisis of 2008, refers to the administrative request to the losing party to increase the guarantee margin in case the market is evolving against the position taken. But, except for the initial margin, the leverage that derivatives offer a potential speculator is almost infinite.
It is therefore better understood why regulatory authorities pay particular attention to the exuberance with which operators, retail or professional, use derivatives. If the danger for the individual investor who speculates with derivatives has been proven by the great Dutch mathematician Christiaan Huygens already in 1657 in his De ratiociniis in ludo aleae, the danger for the systemic equilibrium of the financial markets is empirically demonstrated by the countless crises caused by the reckless use of financial leverage. It is therefore not surprising that, on the basis of accumulated experience, they have been included in all advanced legislation protections to defend less aware investors, effectively making not only "pure" derivatives, but also "structured" products (typically bonds) inaccessible to non-professionals, where the payoff depends randomly on the fulfillment of certain conditions.
Does it follow that derivatives have no place in the tactical management of a portfolio, even a retail one? The answer is negative, but with some clarifications. First, you need to consider the purpose of use. For example, if the goal is diversify into otherwise inaccessible asset classes (we have seen the example of gold), you can buy products that replicate a long position in these asset classes through derivatives (futures, mainly). Another typical example is what could arise in the management of a long-term investment portfolio, when, due to extreme events, you want to temporarily change the risk profile by purchasing a negatively leveraged ETF. These are funds which, through the use of derivatives (swaps or futures), manage to replicate the performance of the underlying market index but with an inverse sign. The important thing is to remember that derivatives are expensive, especially if implemented by funds without expiration (due to the roll-over of positions), and that... the market is like democracy: an imperfect mechanism, but so far no alternative has been found able to process information more efficiently.
In other words, you must always keep in mind that a excess confidence in one's opinions is the sure road to ruin. And, therefore, it is better to give yourself a stop-loss target, do not overdo risk hedging and always be aware that “the market is wrong” it is the epitaph that adorns the tombstones of countless generations of investors.
