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Advantages of Derivatives

Derivative instruments offer several potential advantages over cash market transactions, falling into four broad categories: (1) ability to change risk allocation, transfer risk, and manage risk; (2) information discovery; (3) operational advantages; and (4) improved market efficiency.

1. Ability to Change Risk Allocation, Transfer Risk, and Manage Risk

Risk exposures can be altered using derivatives without any cash market securities transactions. Examples:

• A portfolio manager can increase or decrease exposure to the risk and return of a market index.
• A manufacturer can hedge the exchange rate risk of anticipated receipts or payments.
• The issuer of a floating-rate note can change that exposure to a fixed-rate obligation.

Derivatives can also create risk exposures that are not available in cash markets:

• The owner of common stock can buy puts that act as a floor on the sale price of their shares — reducing downside risk by paying the cost of the puts.
• An investor can acquire the upside potential of an asset without taking on its downside risk by buying call options.

2. Information Discovery

Derivative prices and trading provide information that cash market transactions do not.

• Implied volatility: Options prices depend on observable inputs (interest rates, underlying price, time to expiration, exercise price) and one unobservable input — the expected future price volatility of the underlying. Combining current option prices with the observable variables lets us back out the future price volatility that market participants expect.
• Expected prices: Futures and forwards can be used to estimate expected prices of their underlying assets.
• Expected interest rates: Interest rate futures across maturities can be used to infer expected future interest rates and even the number of central bank rate changes over a future period.

3. Operational Advantages

Compared to cash markets, derivatives markets have several operational advantages — greater ease of short selling, lower transaction costs, greater potential leverage, and greater liquidity.

• Ease of short sales. Taking a short position by selling a forward or futures contract can be straightforward, while borrowing the underlying asset and short-sale restrictions may make direct shorting problematic or expensive.
• Lower transaction costs. Especially for commodities derivatives, where transportation, storage, and insurance add costs to physical transactions. Entering a fixed-for-floating swap to convert floating-rate exposure to fixed is clearly cheaper than retiring a floating-rate note and issuing a fixed-rate note.
• Greater leverage. The cash required for a derivatives position is typically much less than for the equivalent exposure in cash markets.
• Greater liquidity. The low cash requirement makes very large transactions easier to handle.

4. Improved Market Efficiency

Low transaction costs, greater liquidity and leverage, and ease of short sales all make it less costly to exploit securities mispricing through derivatives transactions, which improves the efficiency of market prices.

Risks of Derivatives

Implicit Leverage. The implicit leverage in derivatives gives them much more risk than their cash market equivalents. A lower cash requirement to enter a trade increases leverage. According to the CME Group, futures margins are typically in the 3% to 12% range — implying leverage of 8:1 to 33:1. With required cash margin of 4%, a 1% decrease in the futures price decreases the cash margin by 25%.

A lack of transparency in derivatives contracts and in structured securities (which combine derivative and cash market exposures) may lead to situations where purchasers do not well understand the risks of derivatives or securities with embedded derivatives.

Basis Risk

Basis risk arises when the underlying of a derivative differs from a position being hedged with the derivative. For a manager with a portfolio of 50 large-cap U.S. stocks, selling a forward with the S&P 500 Index as the underlying (in an amount equal to the portfolio value) would hedge portfolio risk but not eliminate it — returns on the portfolio and the index may differ over the life of the forward.

Basis risk also arises when an investor's horizon and the settlement date of the hedging derivative differ — for example, hedging a corn harvest occurring on September 15 by selling corn futures that settle on October 1. The hedge may be effective but is not perfect, and the corn producer is said to have basis risk.

Liquidity Risk

Derivatives have a special type of liquidity risk when the cash flows from the hedge do not match the cash flows of the investor's position. Consider a farmer who sells wheat futures to hedge the value of her wheat harvest. If wheat futures prices rise, losses on the short position essentially offset the higher harvest income (as intended), but those losses can also trigger margin calls during the life of the contract. If the farmer does not have the cash to meet the margin calls, the position will be closed out and the value of the hedge will be lost.

Counterparty Credit Risk

Different derivatives and positions have important differences in the existence and amount of counterparty credit risk:

• Option seller: faces no counterparty credit risk — once the premium is received, the seller will never be owed more at settlement.
• Option buyer: will be owed money at settlement if the option is in the money, and so faces counterparty credit risk.
• Forwards: both buyer and seller of a forward on an underlying asset may face counterparty credit risk.

In futures markets, the deposit of initial margin, daily mark-to-market, and the guarantee of the central clearinghouse together reduce counterparty risk. With forwards there may be no guarantees, or the contract may specify margin deposits, periodic mark-to-market, and a central clearing party to mitigate credit risk.

Systemic Risk

Systemic risk: widespread impact on financial markets and institutions may arise from excessive speculation using derivative instruments. Market regulators attempt to reduce systemic risk through regulation — for example, the central clearing requirement for swap markets to reduce counterparty credit risk.

Derivatives Use by Issuers

Corporate users of derivative instruments are considered issuers of derivatives. A non-financial corporation may have risks associated with changes in asset and liability values as well as earnings volatility from changes in underlying securities or interest rates. Examples:

• A corporation with foreign-currency income may hedge exchange rate risk with forwards to smooth earnings reported in its domestic currency.
• A corporation reporting fixed-rate debt at fair value can enter a pay-floating interest rate swap to convert the fixed-rate liability into a floating-rate (much lower duration) one — making its balance sheet value less sensitive to changes in interest rates.
• A corporation carrying commodity-like inventory at fair market value can sell forward contracts on a matching underlying so that gains/losses on the forwards offset changes in reported inventory value, reducing balance-sheet variability.

Accounting rules may permit hedge accounting, which allows firms to recognize gains and losses of qualifying derivative hedges at the same time they recognize the corresponding changes in the values of the assets or liabilities being hedged. Issuer hedges are classified by their purpose:

• Cash flow hedge. A hedge of the domestic currency value of future receipts in a foreign currency using forwards. A swap that converts a floating-rate liability to a fixed-rate liability is also a cash flow hedge — interest payment cash flows are made more certain.
• Fair value hedge. A hedge that reduces (offsets) changes in the values of the firm's assets or liabilities. Examples: hedging changes in the balance-sheet value of inventory, or using an interest rate swap to reduce the volatility of debt values on the balance sheet.
• Net investment hedge. A hedge that reduces the volatility of the equity value of a foreign subsidiary reported on the parent's balance sheet. Foreign currency forwards or futures can hedge changes in the reported equity value caused by exchange rate changes.

Derivatives Use by Investors

Investors can hedge, modify, or increase their exposure to the risk of an underlying asset or interest rate using either forward commitments or contingent claims. Examples:

• An investor can buy silver forwards to gain exposure to the price of silver, with no or low funds initially required.
• An investor can increase the duration of their bond portfolio by entering an interest rate swap as the floating-rate payer / fixed-rate receiver — economically similar to issuing floating-rate debt and buying a fixed-rate bond with the proceeds.
• An equity portfolio manager can modify market risk exposure temporarily at low cost: increasing it by buying equity index futures or decreasing it by selling equity index futures. Alternatively, the manager could decrease downside risk while preserving upside potential by buying puts on an equity index.