Derivative financial instruments are the building blocks of structured products, and the overall character of structured products is largely a function of their derivative components. Anyone wishing to understand structured products properly must therefore come to grips with derivatives. This chapter provides the necessary basis for such an understanding. It takes a deliberately broad approach, focusing on the way options function and how they are priced while also discussing forwards, futures and swaps.
Derivatives are by nature a zero-sum game. One party’s gain is automatically the counterparty’s loss. Are derivatives then nothing more than a frivolous gamble, in which someone makes a profit at someone else’s expense?
Media reports on the enormous losses and spectacular corporate insolvencies caused by the uncontrolled use of derivative financial instruments are a frequent occurrence: just think of Orange County, Metallgesellschaft AG or Barings Bank. In fall 1998, the widely publicized collapse of the hedge fund Long Term Capital Management (LTCM) shook the global financial system. When Warren Buffett, probably the most famous investor in the world, described derivatives as “financial weapons of mass destruction,” he put into words a long-held fear that derivatives might indeed be dangerous.
Before discussing individual instruments, it is important to first begin with a few basic reflections on the economic utility of derivatives.