What are financial derivatives?

Financial derivatives are securities whose value is ‘derived’ from the value of  primary security such as a stock, currency, government bond or commodity. Primary securities are also called underlying assets. Then, a derivative contract on an underlying asset is a promise to pay a certain amount by one party of the contract to another in a predetermined future date. The amount to be paid depends on the value of the underlying at the termination date of the derivative contract, which is also known as the derivative’s maturity. The most common types of derivative contracts are:

1) Forwards/Futures contracts;

2) Options;

3) Swaps.

Individuals and firms may use derivatives for hedging to manage their risks due to exposure to a risky financial asset. For example, a Turkish firm that imports goods and services from a foreign nation is exposed to price changes in the foreign exchange markets. Suppose the firm needs to pay 100,000 US dollars in six months for the imports from a foreign nation. Suppose also that the current US dollar and Turkish lira exchange rate is 7,30. At this rate, 100,000 US dollars is worth 730,000 Turkish liras. The risk here is the depreciation of the Turkish lira against the US dollar. That is, if the exchange rate increases above 7,30, say 7,90, at the end of the sixth month, the amount to be paid will increase to 790,000 Turkish liras. Thus, the firm will have to pay an extra amount of 60,000 liras (=790,000-730,000) during the payment time. That is, it may risk losing 60,000 liras due to depreciation in the exchange rate. As a protection, the managers of the firm may enter into a six-month forward agreement at a predetermined price to protect the firm against a certain level of potential depreciation in the exchange rate. In that instance, the firm is in a long position in the forward contract. On the other hand, if the firm was an exporter rather than an importer, the managers of the firm may sell a forward contract to realize gains when the Turkish lira appreciates against the US dollar. In that instance, the firm is said to be in the short position in the forward contract. In sum, long position in currency forwards is appropriate when an individual or a firm will buy foreign currency (US dollars in our example) by selling home currency (Turkish lira in our example). A short position is then appropriate for selling foreign currency to buy home currency.

Another use of derivatives is to benefit from arbitrage opportunities in the financial markets. Arbitrage is the potential of making a profit without worrying about losing any money. The simplest example is finding a paid lottery ticket in the street. The finder has the potential of making money without worrying about losing it. Likewise, in some instances, arbitrage opportunities may exist due to the mispricing of financial securities in the market. With the use of derivative contracts, arbitrageurs (investors seeking arbitrage opportunities) may exploit the arbitrage opportunities in the market and bring the prices back into equilibrium. Finally, investors may also use derivatives for speculation. Under certain instances, markets may entire into high risk regime due to instabilities inherent in an economic system. By speculating through derivatives on the direction of the underlying, investors seek to realize high levels of returns. For example, the value of a stock may be expected to increase in the future. An investor may buy an option on the stock to make more gains than he or she can make by buying the stock, because options provide leverage. That is, by investing in options an investor may end up magnifying the amount he or she can gain by solely investing into stocks; for a unit (say 1 lira) gain in the stocks, options have the potential to offer more than a unit (say 7 liras).

Derivatives are traded over-the-counter (OTC) and in exchanges. Exchange traded derivatives (which are futures and options) are standardized securities that are bought and sold in the liquid financial markets. More clearly, exchange traded derivatives are bought and sold like stocks are bought and sold in the stock markets around the world. In other words, thanks to the liquidity of the market their exchange becomes easy; selling and buying of these securities can happen instantaneously. The largest exchanges for exchange traded derivatives are Korea Exchange, Eurex, Chicago Mercantile Exchange (CME). In Turkey, trading of all futures and options contracts are conducted at Borsa Istanbul’s trading platform. The payments of all derivative contracts are guaranteed by a clearinghouse, which is Takasbank in Turkey. Unlike the exchange traded derivatives, OTC derivatives are securities customized based on their buyers’ needs. Once they are initiated, the exchange of OTC derivative contracts cannot be realized as exchange traded derivatives can be. For this reason, the market for these securities is not liquid. Swaps, forward contracts, and certain types of options are OTC type derivatives. According to the statistics of The Bank of International Settlements (BIS), the size of the OTC derivatives is more than 600 trillion US dollars at the end of June 2020. The largest OTC derivative type consists of the contracts on interest bearing securities such as bonds. 

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