2.4 The Derivatives Market
2.4.1 Uses of Derivatives
Derivatives contracts represent agreements either to make payments or to buy or sell an underlying contract at a time or times in the future. The times may range from a few weeks or months (for example, futures contracts) to many years (for example, long-dated swaps). The value of a derivatives contract will change with the level of one of more underlying assets or indices and possibly decisions made by the parties to the contract. In many cases, the initial value of a derivative traded will be contractually configured to be zero for both parties at inception.
Derivatives are not a particularly new financial innovation; for example, in medieval times, forward contracts were popular in Europe. However, derivatives products and markets have become particularly complex in the last couple of decades. One of the advantages of derivatives is that they can provide very efficient hedging tools, for example, consider the following risks that an institution, such as a corporate, may experience:
- FX risk. Due to being paid in various currencies, there is a need to hedge cash inflow in these currencies.
- IR risk. They may wish to transform fixed- into floating-rate debt.
- Commodity. The need to lock in oil prices when energy costs represent a significant portion of gross margin.
In many ways, derivatives are no different from the underlying cash instruments. They simply allow one to take a very similar position in a synthetic way. For example, ...