Uses for Derivatives

Derivatives provide an alternative to simply purchasing a commodity or financial instrument, expanding the range of opportunities and tools available for investors and managers. They are often a less expensive, more efficient tool for:

1. Risk management through hedging
2. Speculation and arbitrage
3. Increasing portfolio returns

Risk Management: Hedging and Insurance

Derivatives can be used as a risk transfer tool by taking the opposite position in the futures market against the underlying commodity. For example, a wheat farmer and a wheat miller could enter into a futures contract to exchange cash for wheat in the future. Both parties have reduced the risk of the future: the uncertainty of the price and the availability of wheat.

Speculation and Arbitrage

Speculators may trade with other speculators as well as with hedgers. In most financial derivatives markets, the value of speculative trading is far higher than the value of true hedge trading. As well as outright speculation, derivatives traders may also look for arbitrage opportunities between different derivatives on identical or closely related underlying assets or securities.

In addition to directional plays (i.e., simply anticipating the direction of the underlying security’s price), speculators can also use derivatives to take a position on the volatility of the underlying security. This technique is commonly used when speculating with traded options.

Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings Bank, made poor and unauthorized investments in index futures. Through a combination of poor judgment on his part, lack of oversight by management, a naive regulatory environment and unfortunate outside events like the Kobe earthquake, Leeson incurred a $1.3 billion loss that bankrupted the centuries-old financial institution. Since that time, the Commodity Futures Trading Commission (CFTC) has continued its evaluation and modification of its rules to ensure greater oversight and accountability in the trading of commodity markets.

Increase Portfolio Returns

Derivatives can help investment managers to better utilize information, manage risk and reduce transaction costs. They also are used to increase portfolio returns by collecting premiums for certain positions, most notably by selling options.

Advanced: Evidence from the Mutual Fund Industry