Conventional markets are concerned with financial securities that have a direct claim to a firm’s earnings. For example, equity instruments have a residual claim on a firm’s earnings in the form of dividends, and debt instruments have a fixed claim on a firm’s earnings, in the form of interests. These markets have mechanisms that facilitate the trading of financial securities (such as equities, debentures, etc.). Their major roles are to provide trading in the underlying financial security, such as equities and debentures; facilitate exchange of ownership rights between sellers and buyers of financial securities; and provide or assure holders that their investment retains some degree of liquidity (because such securities are quoted or listed and therefore bought and sold on an organized exchanged).
There are also markets for derivatives. In addition to the conventional markets, there are also a range of markets in which trading occurs not in the underlying commodity or security itself but in instruments derived from the underlying commodity or security. These securities do not have a direct or immediate claim on a real asset. Instead they have a claim on another security, such as equity or bond. These securities are generally called derivatives.
A derivative instrument is an asset, the performance of which is based on (derived from) the behavior of the price of an underlying asset. The underlying assets (traded in cash/conventional market) may be shares, bonds, commodities, foreign currencies or interest rates, but in each case, the assets themselves do not need to be bought or sold. Some of the common uses of financial derivatives include:
• Hedging the cost of future financing.
• Protect the price of a financial asset to be sold in the future.
• Avoid exposure to large price variation.
• Allow risk-averse investors to minimize exposure.
• Reduce income volatility created by fluctuations in interest rates.
• Hedging a commitment to lend money in the future.
• Hedging the risk of changes in foreign exchange rate.
There are some practical examples to clearly illustrate the need for derivative contracts:
1. Suppose a company plans to obtain a bank loan for $400m two months from now. The key risk here is that two months from now the interest rate will be higher than it is today. If interest rate is only two percentage point higher, the company would have to pay $8m more in annual interest. Clearly, then, issuers/borrowers want a way to protect against a rise in interest rates.
2 A pension fund owns a portfolio of equity shares of a large number of companies. Suppose the pension fund knows that two months from now it must sell shares in its portfolio to pay beneficiaries $35m. The risk that the pension fund faces is that two months from now when the shares are sold, the price of most or all shares may be lower than they are today. If share prices do decline, the pension fund will have to sell off more shares to realize $35m. Thus, investors face the risk of declining share prices and may want to protect this risk.
3. Suppose an apple farmer in the United States plans to export his apple farm produce to a customer based in Germany. A receipt of 200,000 euros is expected in three months’ time. The amount of dollars that the farmer will receive depends on the exchange rate in three months’ time. If in the interval, the euro weakens relative to the dollar, the farmer receives less dollars for his apple. Thus, the American farmer faces foreign exchange risk.
Derivative instruments are available to handle the risks inherent in the above situations.