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In the case of stock, this
may take the form of the company's dividendpayment, the part of aftertax profits distributed to shareholders, or it might take the
formof capital gains realized through the appreciation of the stock's value. Formerly, suchmonetization, or potential for
monetization, would have been more or less directly relatedto the economic performance of the company, in contributing to an
increasing overall rateof wealth generation through productivityenhancing increases in the powers of labor.
Sotoo are bonds directly related to economic activity, though where stocks represent equityownership, bonds represent indebtedness. The
interest paid corresponds, more or less, tothe dividend yield of a stock. And like stocks, bonds can provide capital appreciation.A
generation ago, such financial instruments were the means for transforming economicsurplus into monetized net profit. ``Hard''
commodities are different, because they are partof the materials-flow needed to sustain production and consumption, which ought to
bebought and sold so that production might proceed-outputs of production on the one side,are also the inputs for the next level of
productive transformation on the other: Wheatbecomes flour, flour becomes bread; iron ore becomes steel, steel
becomes machinery,buildin gs, automobiles, and household appliances. Such activities used to contribute togeneration of
surplus, but their monetization is not part of aftertax profits.Purchases of stocks and bonds would once have been seen as
investment for the long haul.Trade in commodities would have been seen not as investment, but as purchases and sales.With what
are now called derivatives, we move from investment, and purchases and salesof hard commodities, to speculating on the
future price or yield performance of what wereonce investments, and relatively simple, economically necessary transactions.All
derivatives are actually variations on futures trading, and, much as some insist to thecontrary, all futures trading is inherently
speculation or gambling. Thus until late in 1989, allfutures trading, of any sort, was outlawed in Germany, under the country's
gambling laws.Such activities were not treated as a legitimate part of business activity. And, who willcontend
against the observation, that Germany did quite well without them? There are two types of futures trading; each can
be applied to each of the instruments, likestocks and bonds, which, bought directly for cash, monetize what used to be
after-taxprofits. The first type is, as it were, a second step removed from economic activity as such.This is futures trading per
se: contracting to buy or sell at a future date, at a previouslynegotia ted price. Here the presumption used to hold, that commodities, for
example, wouldactually change hands for money, as the agreed-on contracts fell due.The other kind of futures
contract, called an option, moves another step further away fromeconomic activity as such. Now what is bought or sold is
the right, but not the obligation, tobuy or sell a commodity, stock, bond, or money, at a future price on an agreed-on date.Where the
futures contract speculates on what the price that would have to be paid againstdelivery will be, the option simply speculates
on the price.At yet another remove from economic activity per se is an index. An index is not the right tobuy a commodity or
stock in the future which is traded, but the future movement of anindex based on a basket of stocks, commodities,
bonds, or whatever.
Types of derivatives
The most commonly used derivatives contracts are
forwards, futures and options which weshall discuss in detail later. Here we take a brief look at various derivatives
contracts thathave come to be used.
: A forward contract is a customized contract between two entities, where
settlement takes place on a specific date in the future at today’s pre
: A futures contract is an agreement
between two parties to buy or sell an asset at acertain time in the future at a certain price. Futures contracts are special types
of forwardcontracts in the sense that the former are standardized exchange-traded contracts
: Options are of two types - calls and puts. Calls give the buyer the right but not theobligation to buy a given quantity of the
underlying asset, at a given price on or before agiven future date. Puts give the buyer the right, but not the obligation to sell a givenquantity of
the underlying asset at a given price on or before a given date.
: Swaps are private
agreements between two parties to exchange cash flows in thefuture according to a prearranged formula. They can
be regarded as portfolios of forwardcontracts. The two commonly used swaps are:
Interest rate swaps
: These entail swapping only the interest related cash flowsbetween the parties in the same currency.
: These entail swapping both principal and interest between theparties, with the cash flows in one direction
being in a different currency than those in theopposite direction.
: Options generally have lives of upto one
year, the majority of options traded onoptions exchanges having a maximum maturity of nine months. Longerdated options
arecalled warrants and are generally traded over-thecounter.
: The acronym LEAPS means Long-Term Equity
Anticipation Securities. These areoptions having a maturity of upto three years.
: Basket options are options on portfolios of
underlying assets. The underlying assetis usually a moving average or a basket of assets. Equity index options are
a form of basketoptions.
: Swaptions are options to buy or sell a swap that will become operative at theexpiry of the
options. Thus a swaption is an option on a forward swap. Rather than havecalls and puts, the swaptions market
has receiver swaptions and payer swaptions. A receiverswaption is an option to receive fixed and pay floating. A
payer swaption is an option to payfixed and receive floating.
Participants and Functions
Three broad categories of participants hedgers, speculators, and arbitrageurs trade in
face risk associated with the price of an
asset. They use futures
Source: Options Futures & Other Derivatives John C Hull
or options markets to reduce or eliminate this risk.
wish to bet on futuremovements in the price of an asset. Futures and
options contracts can give them an extraleverage; that is, they can increase both the potential gains and potential losses in
are in business to take advantage of a discrepancybetwe en prices in two different markets.
If, for example, they see the futures price of anasset getting out of line with the cash price, they will take offsetting
positions in the twomarkets to lock in a profit.The derivative market performs a number of economic
functions. First, prices in anorganized derivatives market reflect the perception of market participants about
the futureand lead the prices of underlying to the perceived future level. The prices of derivativesconver ge with the prices
of the underlying at the expiration of derivative contract. Thusderivatives help in discovery of future as well as current prices.
Second, the derivativesmarket helps to transfer risks from those who have them but may not like them to thosewho have appetite for
them. Third, derivatives, due to their inherent nature, are linked tothe underlying cash markets. With the introduction of
derivatives, the underlying marketwitnesses higher trading volumes because of participation by more players who would
nototherwise participate for lack of an arrangement to transfer risk. Fourth, speculative tradesshift to a
more controlled environment of derivatives market. In the absence of anorganized derivatives market,
speculators trade in the underlying cash markets. Margining,monito ring and surveillance of the activities of various
participants become extremelydifficult in these kind of mixed markets. Fifth, an important incidental benefit
that flowsfrom derivatives trading is that it acts as a catalyst for new entrepreneurial activity. Thederivatives
have a history of attracting many bright, creative, well-educated people with anentrepreneurial attitude. They often energize
others to create new businesses, newproducts and new employment opportunities, the benefit of which are immense. Sixth,derivatives
markets help increase savings and investment in the long run. Transfer of riskenables market participants to
expand their volume of activity. Derivatives thus promoteeconomic development to the extent the later depends on the
rate of savings andinvestment.
Development of exchangetraded derivatives
Derivatives have probably been around for as long as people have been trading with oneanother. Forward contracting dates
back at least to the 12th century, and may well havebeen around before then. Merchants entered into contracts with one another
for futuredelivery of specified amount of commodities at specified price. A primary motivation forprearranging a
buyer or seller for a stock of commodities in early forward contracts was tolessen the possibility that large swings
would inhibit marketing the commodity after aharvest. Although early forward contracts in the US addressed merchants’
concerns about ensuring
that there were buyers and sel lers for commodities, “credit risk” remained a serious
problem. To deal with this problem, a group of Chicago businessmen formed the
Chicago Board of Trade
(CBOT) in 1848. The primary intention of the CBOT was to provide acentralized location known in advance for
buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first “exchange traded” derivatives
contract in the US; these contracts were called “futures contracts”. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT,
was reorganized to allow futures trading. Its name waschanged to
Chicago Mercantile Exchange
(CME). The CBOT and the
CME remain the twolargest org anized futures exchanges, indeed the two largest “financial” exchanges of any kind in the world today.The first
stock index futures contract was traded at
Kansas City Board of Trad
e. Currentlythe most popular index futures contract in the
world is based on S&P 500 index, traded onChicago Mercantile Exchange. During the mid eighties, financial futures became the
mostactive derivative instruments generating volumes many times more than the commodityfutures
. Index futures, futures on T-bills and Euro-Dollar futures are the three most popularfutures contracts traded today. Other
popular international exchanges that trade derivatives
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