Derivatives

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OVERVIEW

Historically, it has been believed that financial derivatives are instruments for hedging risks. Moreover, it can definitely be stated that hedging risks is the core idea behind the concept of derivatives. However, in recent times, derivatives have begun to be viewed not only from the perspective of hedging risks, but also (and surprisingly – even primarily) as tools for receiving super-income.

In a narrow sense, derivatives may be defined as temporary contracts and special conditions for conclusion and execution thereof. Within the broad meaning, derivatives are any market tools which are based on any primary assets – money, securities, goods, property. They are used for receiving the highest level of income in circumstances of high risk, reducing taxes, etc.

 

HISTORY OF DERIVATIVES

Since ancient times, merchants encountered problems where they needed special instruments in order to solve them. To illustrate, in cases of long-distance trade, merchants had to finance the shipping of goods and problems could arise throughout the shipping road as well. The goods could be lost for some reasons (for example, the vehicles transporting the goods could be attacked by pirates). Thus, due to long periods of time needed for shipping, fluctuations in the prices of goods could occur.

Due to circumstances mentioned above, contracts on division of risks started to conclude under which creditors gave loans to merchants (the rates whereof were dependent on the luck of the trade) and which can be considered as ancestors of contemporary options.

In the Middle Ages – especially after the collapse of the Roman Empire in the 12th century, such trade centers developed as Venice and Genoa in Italy and Flanders in Northern Europe. Naturally, these centers quickly became engaged in active trade between each other. Goods from different parts of Europe began to be traded on medieval fairs. It was in such fairs that an instrument letter de faire appeared, which was in essence, a forward agreement on distribution of goods within a specified period of time. Under these contracts, a merchant could, for example, sell the goods to be transported to other persons which was undertaken to transport the goods to a particular spot. After the transportation was over, the merchant who initially sold the goods repurchased the goods at a higher price (the price was mentioned in the contract and calculated in such a way that reflected the price of transportation and hedged the risks inherent to that).

Although the instruments mentioned above possessed some qualities of derivatives, they were not so formal. The first formal derivatives appeared on Japanese Dojima Rice Exchange, which operated in Osaka and existed until the Second World War. In 1730, a trade of futures began on Dojima Exchange. It is spectacular that trade possessed all the qualities inherent to contemporary futures: the volume of all contracts was fixed, the same and the terms of the contracts were established in accordance with three time periods (Summer, Winter, Spring) of trade calendars. All payments were made in cash (regardless of actual shipping of rice).

In the beginning of the 19th century, the fluctuation of prices in the US wheat market ended in further development of derivatives. As a result of the conclusion of many forward agreements, Chicago became a center of wheat preservation wherefrom it was further transformed to other locations. As a result of continuant development of forwards in 1848, the Chicago Stock exchange started trading futures which were more convenient and ensured better protection from unexpected circumstances and better hedging of risks. Raw agrarian goods and natural resources become objects of futures trade.

In the present era, development of derivatives is closely related to currency exchange rates. In particular, volatile rates made the financial system full of risks, as a result of which options, swaps, swaptions and other complicated financial instruments appeared.

 

MAIN TYPES OF DERIVATIVES

Notwithstanding the absence of an exhaustive list of all types of derivatives (any instrument possessing certain features may be qualified as a derivative), both theorists and legislatives consider four instruments – options, futures, forwards and swaps – to be the main types of derivatives.

 

FORWARDS

A forward agreement is an agreement under which one party undertakes to transfer goods (underlying asset) to the other party within the designated period of time or to execute an alternative money obligation, and the other party undertakes to accept the underlying asset and pay for it, and under which the cross money obligations of the parties depend on some indicators of the underlying asset.

 

FUTURES

A futures agreement is an agreement under which two parties – usually the Seller and the Buyer agree over sale and purchase of certain asset(s) at a designated point of time in the future and at a designated price.

 

OPTIONS

Options may be derived from different types of transactions, e. g. – shareholders’ agreements.

Put option is a right or possibility of one party to demand from the other party to purchase the underlying asset belonging to the first party under the terms and conditions established by the put option agreement. Thus, in the case of expression of such demand, the second party shall be obliged to purchase the underlying asset.

Call option is the right of one party to purchase the underlying asset belonging to the other party.

In other words, option agreements imply rights for one party – the right to purchase or the right to demand sale, which means that such parties – put holders or call holders are free in deciding whether to exercise the option or not. On the contrary, for the opposite parties options imply obligations. Thus, in case the holder desires to exercise the option the opposing party becomes obliged to buy or sell the asset, dependent on whether a put or call option agreement has been concluded.

 

SWAPS

A swap agreement is an agreement between two parties under which the latter undertakes obligations related to future exchange of payments under the terms and conditions established by the swap agreement. Occasionally, it is stated that swaps are not derivatives in a classical sense since these instruments do not derive from securities.

Swaps are widely used for mitigating market and credit risks. There are different types of swaps. For example, under a ratio swap agreement, the parties to the agreement undertake to exchange payments in the course of a specified period of time. That period of time may differ and take from 2 to 15 years. One of the parties pays amounts calculated on the basis of a fixed rate mentioned in the agreement and the other one – on the basis of a fledgling rate – often LIBOR. The party making fixed payments is often referred to as the buyer of the swap and the party making payments under fledgling rate – the seller of the swap. The convenience of such agreements is conditioned by differing expectations regarding economic outcomes. Another type of swaps is the currency swap. Currency swap is an exchange of fixed ratios of two different currencies. The convenience of this instrument may be conditioned by, for instance, the wish to hedge currency risks or desire to issue bonds in another country (with another currency).

 

HOW CAN WE HELP?

Our team is sophisticated in drafting elaborate derivatives for the benefit of our clients. That is why do not hesitate to contact us in case you need careful advice on some of the issues discussed.