Headlines in the financial press often include the word "derivatives," usually associated with a problem, loss or conflict. But, what are derivatives? How are they used? Why are these securities so often the object of derision?
          Following is a brief exploration of derivatives, aka synthetic securities.
          Derivatives began as the combination of an asset with an agreement to buy or sell that asset as a specified price. Thus the term "synthetic security." The intent was to limit (or transfer) the risk of loss.
          The transfer of risk is accomplished through the use of option or futures contracts. Due to the number of possible combinations, options and futures contracts can be a bit mystifying and complicated at first. Yet they are nothing more than either a promise to buy or a promise to sell.           These promises to buy or sell are linked to everything from specific commodities (orange juice or sugar) to the stock market and money itself. Options and futures contracts may also apply to overall market indices such as the S&P 500 or Dow Jones Industrial Average.
          A basic example is: an investor owns XYZ security purchased for $100. While holding that security, the investor assumes all of the risk of the price either rising or falling. Theoretically, the risk of loss is $100 and the reward is unlimited. If this risk is too large, the investor also enters into an agreement to sell XYZ security at $80 anytime within the next 12 months.
          The combination of these two securities creates a synthetic investment with a guaranteed loss limit of $20, hence a derivative. The fees associated with entering into the options contract is the premium for this risk of loss insurance.
          Since 1977 when the Chicago Board of Trade introduced a futures contract based on the U.S. 20-year bond, the market for derivative securities has become very large. Worldwide, these securities provide "insurance" on an estimated $16 trillion of financial instruments. Their economic function is to transfer risk from those who do not want to bear it to those who are willing to bear it for a fee.
          Derivatives are also commonly used by companies involved in international trade. Fluctuations in currency exchange rates represent a high degree of risk.
          The most active derivatives in currencies include: Deutschemark/dollar; Japanese Yen/dollar; Swiss Franc/dollar; British Pound/dollar; French Franc/dollar. As a further hedge against international volatility, international equity indices are also used to create derivative securities that limit risk. Examples include: the S&P 500 Index (U.S.A.); Nikkei 225 Index (Japan); CAC 40 Index (France); FTSE-100 index (UK); DAX Index (Germany).
          Creating a derivative security based upon an instrument the investor already owns is called "hedging." Hedgers are farmers, manufacturers, importers and exporters, and securities investors. A hedger buys or sells in the futures markets to secure the future price of a commodity intended to be sold at a later date. This helps protect against price decrease.
          Entering into options or futures contracts (sometimes more than one at a time) without owning the underlying security is referred to "speculation," or "being naked."
          Speculators do not aim to minimize risk but rather to benefit from the inherently risky nature of the futures market. Speculators aspire to profit from the price change that hedgers are protecting themselves against. In other words, rather than transferring existing risk, the speculator hopes that the hedging activities of others will increase the price of the option or futures contract for themselves.
          This is the cause of the negativity and disapproval regarding derivatives. As hedging activities within companies increase and become more intricate, the risk of loss rises. Firm may unintentionally find themselves speculating rather than hedging simply because of multifarious positions created by simultaneous derivative positions. Another factor may be the lure of excess profits from speculating on top of an existing hedging activity.
          In March, 2004 it was reported that Fannie Mae paid a net $25.1 billion for derivatives transactions in fewer than four years - nearly all of which may represent losses that cannot be recouped. Gibson Greetings and Proctor & Gamble lost $20 million and $157 million respectively from derivative transactions.
          In response to rising concerns that derivatives were undermining the basic efficiency and stability of financial markets, The Financial Economists Roundtable concluded that derivatives serve a highly useful risk-management role for both financial and non-financial firms.
          Although some major derivative users, mutual funds, hedge funds, securities firms, and even banks have incurred derivatives-related losses, most of these losses have been due to inadequate risk-management systems and poor operations control and supervision.
          However, these losses have not threatened the overall stability and efficiency of financial markets. The best discipline against risk in any market, including derivatives, is to ensure that participants have an incentive to manage themselves prudently.