The derivatives scare

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There is nothing new about derivatives. They have been in use since the 18th century when agriculturalists used them to hedge their agri-commodities exposure. It was only once we knew how to price these, thanks to the Black-Scholes-Merton equation, that they became popular on Wall Street. With their rise, we were introduced to a strange new beast—the quants. These physicists and math PhDs brought with them their deterministic bias to solve problems in finance. The result was highly structured products that could be customised for specific purposes and had the propensity to make news headlines for the wrong reasons.

As the name suggests, these are securities that provide special features on an underlying asset such as equity or debt (currency and interest rates) and even weather impact. There are two types of derivatives: the standardised type that are traded on the exchanges and the structured products that you transact with a financial institution (FI), also called over-the-counter products.

The underlying idea has remained the same: derivatives transfer risk, much like life insurance. Just as an insurance premium is a fraction of the insured amount, derivatives are much cheaper than underlying assets. But unlike insurance that require an insurable interest (it is rendered void if you don’t), derivatives are notionally priced on the underlying asset. An option to buy Reliance shares, for instance, has no direct impact on the stock itself. And so we come to the real reason these products have caught the popular imagination—gearing and its speculative potential.

The great advantage and also drawback is the inherent leverage worked into these products. You can buy a unit of 100 shares for about 1/10th the price or lower. This excites speculators and arbitrageurs—especially in debt and currency markets, with only a few basis points to play with. Nothing wrong so far, just a tool for efficient trade. The problem is that the pricing is complex. In options, for instance, there are six variables that interact and change one another. A directional bet with these instruments can go wrong easily. So, how is the risk managed? Through hedging or reverse trades. For companies, that means that they have debt or cashflow in currencies that they are hedging and for FIs (counterparty), it means spread trades that limit the exposure within defined limits. Naked directional positions are an invitation for trouble.