Anthony Galliano, chief executive officer of Cambodian Investment Management, tackles derivatives in the latest of his weekly columns explaining financial terms.
Derivative have historically developed a severely tarnished reputation.
They have been allegedly been responsible for such catastrophic financial disasters such as the bankruptcy of Barings Bank in 1995, the loss of US$7.2 billion by Societe Generale in 2008, and most recently, the Financial Crisis of 2008.
George Soros, the famous hedge fund manager and financier, claims he really doesn’t understand derivatives. The world’s most famous investor, Warren Buffet, called them “financial weapons of mass destruction”.
However, it is the misuse of derivatives that has substantially been the underlining cause of financial tragedies.
A derivative is a financial instrument, which is an agreement or contract between two parties, whose characteristics and value is nearly always linked to the price movements of an underlying asset.
The most common forms of derivatives are options, futures, and forwards which can be linked to assets such as shares, bonds, currencies, and commodities.
They are generally traded in two ways. Over-the-counter derivatives are privately negotiated contracts between two parties. Exchange-traded derivative contracts are traded through either a specialised derivatives exchange or other exchange.
Their primary uses are for hedging, a form of risk mitigation or insurance, or speculation, for the purpose of making a profit.
Derivatives can provide leverage in that a small movement in the underlying asset can result in a large difference in the value of the derivative.
Admittedly derivatives are complex and in explaining them it is best use a basic example.
In Cambodia, our largest agricultural commodity is rice. If a farmer wishes to lock in a price for his harvest he can enter into an agreement or contract with his buyer today, to sell the rice at a specific price, at a future date.
The farmer may wish to mitigate his risk that the price of rice may decline at harvest time and therefore prefer to have certainty of price now rather than be exposed to future price movements.
The buyer may also wish to lock in a price now from the farmer, and speculate that the price will be higher in the future, therefore earning a profit, as the buyer can sell the rice above the price agreed with the farmer.
In this case a derivative is created, an over-the-counter futures contract with the underlying asset being rice and the characteristics being the price agreed and the time of delivery.
The farmer is committed to deliver the rice to the buyer on that date and at the price agreed in the contract.
If this contract can be traded on an exchange, then it would become an exchange-traded derivative.
Derivatives allow businesses to protect themselves against risk such as commodity price movements, increases in interest rates, and adverse movements in exchange rates, therefore having a stabilising and positive effect on the economy.
However, their misuse can result in enormous losses that have a severely damaging effect on the party involved, and possibly the whole economic system.