Derivative Markets and Instruments
The concept of risk is at the heart of investment management. Financial analysts and portfolio managers continually identify, measure, and manage risk. In a simple world where only stocks and bonds exist, the only risks are the fluctuations associated with market values and the potential for a creditor to default. Measuring risk often takes the form of standard deviations, betas, and probabilities of default. In the above simple setting, managing risk is limited to engaging in stock and bond transactions that reduce or increase risk. For example, a portfolio manager may hold a combination of a risky stock portfolio and a risk-free bond, with the relative allocations determined by the investor’s tolerance for risk. If for some reason the manager desires a lower level of risk, the only transactions available to adjust the risk downward are to reduce the allocation to the risky stock portfolio and increase the allocation to the risk-free bond.
But we do not live in a simple world of only stocks and bonds, and in fact investors can adjust the level of risk in a variety of ways. For example, one way to reduce risk is to use insurance, which can be described as the act of paying someone to assume a risk for you. The financial markets have created their own way of offering insurance against financial loss in the form of contracts called derivatives. A derivative is afinancial instrument that offers a return based on the return of some other underlying asset. In this sense, its return is derived from another irlstrument-hence, the name.
As the definition states, a derivative’s performance is based on the performance of an underlying asset. This underlying asset is often referred to simply as the underlying.’ It trades in a market in which buyers and sellers meet and decide on a price; the seller then delivers the asset to the buyer and receives payment. The price for immediate purchase of the underlying asset is called the cash price or spot price. A derivative also has a defined and limited life: A derivative contract initiates on a certain date and terminates on a later date. Often the derivative’s payoff is determined andlor made on the expiration date, although that is not always the case. In accordance with the usual rules of law, a derivative contract is an agreement between two parties in which each does something for the other. In some cases, as in the simple insurance analogy, a derivative contract involves one party paying the other some money and receiving coverage against potential losses. In other cases, the parties simply agree that each will do something for the other at a later date. In other words, no money need change hands up front. We have alluded to several general characteristics of derivative contracts.