Derivative securities - these are financial objects that are not assets in the usual sense. That is, they do not embody part of the property of the enterprise and are not debt obligations. They do not represent the asset itself, but the right to buy or sell it. An investor or a speculator does not acquire it as it happens when buying shares, but use it exclusively for further resale.
What are
There is a special type of financial instrument that is used by financiers and professional traders in the secondary market. These are derivative securities. These include market objects such as options, forwards, futures, etc.
Although the contract itself does not give ownership of the assets, moreover, if you do not sell it on time, it loses its value, investment and speculation with them are considered a profitable business. To understand how a trader can make money on these securities, you need to consider in detail and study at least the main types of derivative securities and their characteristics.
Reasons for the emergence of the secondary market
It all started in 1971, when the first liberalization of the foreign exchange, and then the stock and commodity markets. This led to even greater freedom of movement of capital from one country to another, from one area of production to another. At the same time as freedom, unpredictability of prices came. This is precisely what created the fear of losing part of the capital on the price and the desire of investors to somehow secure their investments.
For completely natural reasons, participants appeared on the market who decided to help particularly fearful investors, and at the same time earn money on them. And although derivative securities are still considered one of the most risky objects of exchange speculation, hunters to use the current market situation does not become smaller. The point is not only high liquidity, but also the simplicity (as the experience of the illusory shows) of using contracts for personal enrichment.
The main reason for the emergence of the derivatives market is the free market itself, when some companies are trying to play safe, others need funds now, they are ready to sell their contracts and assets in order to buy them, but only a little later. Therefore, this market is considered to be secondary, since in it a transaction does not occur between two parties to an agreement (contract), but between third parties to the market: traders and brokers.
Another reason is an attempt to avoid the “collapse” of the economy as a result of another financial crisis, as it was in 1929, when technological progress led to the appearance of new agricultural machinery: tractors and combines. Record (by that standards) harvesting due to the use of this agricultural machinery has led to a fall in agricultural prices and the majority of farmers go bankrupt. After that, there was a sharp rise in prices, as supply fell sharply. There was a collapse in the economy. In order to avoid a recurrence of such a development of the event, they began to sell the future crop under a contract, which even before sowing, its price and volume were stipulated.
Types of Securities
According to the modern definition, the concept of derivative securities is defined as a document or an agreement giving its owner the right to receive an asset within a certain time or after a certain period. In this case, before the transaction, he can dispose of this document. He can sell it or exchange it. The following types of contracts are used in entrepreneurial activity:
- Options.
- Futures.
- Spot contracts.
- Depositary receipt.
- Forwards.
In some scientific articles, a bill of lading is also given as derivative securities, but its inclusion in this type of securities is very controversial. The thing is that the bill of lading does not give the right to dispose of the transported assets. That is, it is an agreement between the shipper and the carrier, and not between the shipper and the consignee. And although the carrier is responsible for the safety of the transported assets (cargo), he does not have the right to dispose of them.
If the consignee refuses to accept the asset, the carrier will not be able to sell or assign it. However, the bill of lading itself may be transferred or sold to another carrier. This gives it a resemblance to derivative securities.
How to classify such financial instruments
In economic science, the classification of derivative securities is adopted according to the following parameters:
- by execution time: long-term (more than 1 year) and short-term (less than 1 year);
- by level of responsibility: mandatory and optional;
- by the date of the consequences of the transaction or the need to pay: instant payment, during the contract or at the end;
- in the order of payments: the whole amount at once or in parts.
All of the above parameters should be somehow specified in the contract. This depends not only on what type it will relate to, but also how transactions with derivative securities, to which the contract applies, will be made.
Forwards
A forward contract is a transaction made by two parties, under the terms of which an asset is transferred, but with a deferral of execution. For example, a contract for the delivery of a product by a certain date. Such a transaction is in writing. At the same time, the value of the acquired (sold) asset and the amount that it will be required to pay for it (market price) should be spelled out in the document.
If the buyer is unable for any reason to pay for the contract or if he urgently needs money, he may resell it. The seller has exactly the same rights if the buyer refuses to pay. In this case, an arbitrage transaction is conducted, as a result of which the affected party may sell the contract on the derivatives market. In this case, the financial result of the transaction can be realized only after the expiration of the period specified in the contract. The price of the contract depends on the duration of the contract, the value of the underlying asset, demand.
There is an opinion among economists that forwards have low liquidity, although this is not entirely true. The liquidity of a forward contract depends primarily on the liquidity of the underlying asset, and not on market demand for it. This is due to the fact that this type of contract is concluded outside the exchange. Responsibility for its implementation lies only with the parties to the contract. Therefore, participants have to conclude a transaction, if they do not want to take another risk, check each other's solvency and the presence of the asset itself.
Futures
Futures contracts, unlike forward contracts, are always concluded on the stock or commodity exchange, but the bulk of financial transactions with them are carried out on the secondary securities market. The essence of the transaction is that one party agrees to sell the asset to the other party by a certain date, but at the current price.
For example, a contract was signed for the purchase of goods at a price of $ 500, which the buyer must return the contract in two weeks. If in two weeks the price has risen to $ 700, then the investor, that is, the buyer, will benefit, because if he had not been safe, he would have to pay $ 200 more. If the price drops to $ 300, then the seller of the contract will still not lose anything, as he will get the contract back at a fixed price. And although in this case the buyer is at a loss (he could buy a contract for $ 200 cheaper), futures give trading a more predictable character.
As derivative securities, futures contracts are highly liquid. The main advantage of this kind of contract is that the conditions for their sale are the same for all participants. Futures trading has its own characteristics (including pure speculation). So, with an open position, the person who performed this operation must deposit a certain amount as a security - the initial margin. The size of the initial margin is usually 2-10% of the amount of the asset, however, by the time the contract is due for implementation, the deposit amount should be 100% of the specified amount.
Futures is one of the high-risk derivatives. After opening a position on the contract price, market forces begin to act. Price may fall or rise. At the same time, time limits apply - the duration of the contract. To ensure stability in the market and limit speculation, the exchange sets limits on the level of deviation from the original price. Orders to buy or sell outside these limits will simply not be accepted for execution.
Options
Options relate to the type of derivative securities with a conditional term of validity. And although options are recognized as the most risky type of transactions (despite some restrictions, which will be discussed in more detail below), they are becoming increasingly popular, as they are concluded at different sites, including the currency exchange.
Upon purchase, the party acquiring the contract agrees to transfer it for a premium at a fixed price to the other party after a certain period of time. An option is the right to buy a security at a certain rate for some time.
For example, one participant buys a contract for $ 500. The contract is valid for 2 weeks. The size of the prize is $ 50. That is, one side receives a fixed income of $ 50, and the other - the opportunity to purchase shares at a bargain price and sell them. The value of an option largely depends on the value of the shares (assets) and price fluctuations on them. If the owner of the option initially acquired 100 shares at a price of $ 250 each, and a week later sold at a price of $ 300, then he made a profit of $ 450. However, in order to receive it, he must complete this operation before the contract expires. Otherwise, he won’t get anything. The difficulty of trading options lies in the fact that you have to take into account not only the value of the option itself, but also the assets to which it applies.
Options are of two types: purchase (call) and sale (put). The difference between the two is that in the first case, the issuer, which issued the derivative of the security, agrees to sell it, in the second - to redeem it. That is, no matter what the situation is in the market, it must fulfill obligations. This is its main difference from other types of contracts.
Spot contracts
Derivative securities also include spot contracts. Under a spot transaction is meant a trading operation that should happen in the future. For example, a spot contract for the purchase of currency for a certain period of time and at a predetermined price. As soon as the conditions for the conclusion of the transaction come, it will be concluded. And although these contracts are not the subject of bidding, their role in exchange trading is great. With their help, it is possible to significantly reduce the risk of losses, especially in conditions of strong market volatility.
Hedging
A hedge is a risk insurance contract drawn up between the insurer and the policyholder. Most often, the object is the risk of non-payment, loss (damage) of assets due to natural disasters, technological disasters, negative political and economic events.
An example is hedging bank loans. If the client cannot pay for the loan, he can sell insurance in the secondary market, with the obligation to redeem it within a certain time. If he does not, the asset becomes the property of the new owner of the insurance, and the insurance company will compensate for the loss of the bank. However, such a system led to sad consequences.
That collapse of the hedge market has become one of the most striking signals of the financial crisis that began in 2008 in the United States. And the reason for the collapse was the uncontrolled issuance of mortgage loans, under which banks bought insurance (hedges). Banks believed that insurance companies would solve their problem with borrowers if they could not pay off the loan. As a result of delay in loans, a huge debt was formed, many insurance companies went bankrupt. Despite this, the hedge market has not disappeared and continues to work.
Depositary receipt
Using this financial instrument, you can purchase assets, stocks, bonds, currency, which for some reason are not available to investors from other countries. For example, by virtue of the national legislation of a country that prohibits the sale of the assets of certain enterprises abroad. In fact, this is the right to acquire, albeit indirectly, the securities of foreign companies. They do not give management rights, but as an object of investment and speculation can bring quite good profits.
Depositary receipts are issued by the depositary bank. First, he buys shares in enterprises that do not have the right to sell their shares to foreign investors. Then issues secured receipts for these assets. These receipts can be purchased in foreign derivatives markets and in the local currency market. Issued securities have a par - this is the name of the company and the number of shares under which they are issued.
Receipts are issued when a certain company wants to register already traded securities on a foreign exchange. They are traded either directly or through dealers. They are usually classified by country of manufacture. This is how depository receipts are distinguished as Russian, American, European and global.
Pros of using such financial instruments
The listed derivative securities often share several types at once. For example, when concluding a futures or option, one of the participants may try to reduce the risk of loss by simply insuring the deal. As long as the contract is valid, he can sell the insurance policy (hedge). If the other party fails for some reason to fulfill the terms of the contract, then the insurance holder will receive insurance payments (the last who bought the insurance).
Despite the fact that these financial instruments are imperfect, they still provide an opportunity for businessmen to reduce risk, add some certainty to the relationships between market participants, and obtain a more or less predictable financial result from the transaction.