Options, futures, and other derivatives: An introduction

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By Doug Awad

Derivatives: Investments once removed. A derivative is a financial instrument whose value is based on, or derived from, the price of another financial instrument. Just as a Chinese translation of a book originally written in English is considered a derivative work for copyright purposes, a derivative security may be based on the price of a commodity such as oil or wheat, a security such as a stock or bond, an index of securities, such as the S&P 500 Composite Index, or a currency. A derivative is essentially a promise to convey ownership of the asset on which it is based, called the underlying asset; it does not represent ownership of the asset itself. When you buy a derivative, you’re not buying something tangible, like a commodity or shares of the company. You’re betting on how the financial instrument or asset that underlies it will perform. It’s a bit like betting on a horse race. You are not buying the horse, you’re betting on how well you think the horse will do. The underlying asset is often something that fluctuates dramatically or frequently. Those changes also affect the price of the derivatives based on that asset.

How are derivatives used? Derivatives are primarily used in two ways. They can help hedge funds against specific risks involved in owning the underlying asset—for example, the risk that a commodity’s price will rise or fall unexpectedly, or the risk that a corporate borrower will default on a bond. However, derivatives also are increasingly used as speculative investments in and of themselves. Institutional investors, such as hedge funds, pension funds, and managers of mutual funds, may use derivatives as part of complex investing strategies. They are often used in conjunction with other techniques – such as buying on margin, to try to maximize the return on invested capital. However, such complex strategies also have been known to create problems even for highly knowledgeable money managers. Derivatives can be used as a hedge against other investments. When used to balance other forms of risk, they function almost like insurance. In essence, by buying certain types of derivatives as part of an overall strategy, an investor is paying a premium to try to protect other parts of the portfolio.

Types of derivatives 1. Options: Purchasing an option gives you the right (but not the obligation) to buy or sell a specific asset at a specific price by a specific time. Option contracts are written on many different types of securities, including common stock, stock or other indices, government debt, commodity futures contracts, foreign currencies, interest rate futures, and precious metals. An option falls into one of two categories: calls, which convey the right to buy the underlying asset, and puts, which convey the right to sell the underlying asset. You can buy or sell both puts and call. 2. Futures: Like options, futures contracts are traded on exchanges and represent an agreement to deliver an underlying asset – typically a commodity, a quantity of a given currency, or a financial instrument – at a specific time for a specific price. However, a futures contract represents a legal obligation to transfer the underlying asset; unlike an options buyer, who can decide whether or not to exercise the option, the buyer of a futures contract has no choice but to take delivery. 3. Credit derivatives/Collateralized debt obligations: These are agreements that essentially transfer risk from one party to another. They represent an attempt to reduce losses from a financial event that affects the value of a debt instrument – for example. a company defaulting on its loan, a change in interest rates, a change on a bond’s rating, or currency fluctuations. They also can be used by institutional investors to gain access to types of credit that are in short supply or create a market for debt during periods of low liquidity. Their use by hedge funds and other institutional investors has increased rapidly—as we all know from listening to the mortgage bailout proposals. Derivatives created from multiple debt instruments and backed by that debt are generically known as collateralized debt obligations (CDOs). Depending on the type of debt that is pooled, the new derivative might be a collateralized bond obligation (CBO), an investment-grade security backed by a pool of bonds that include varying levels of risk; a collateralized mortgage-obligation based on a pool of mortgages; or a collateralized loan obligation (CLO), backed by a pool of commercial or personal loans.

Risks associated with derivatives – some derivatives provide limited risk but unlimited gain potential. Others offer limited gain potential but unlimited loss potential. Investing in derivatives generally carries a high degree of risk that may result in the investor not getting back the amount of his or her original investment. The risks involved will depend on the type of derivative, but may include interest rate risk, market risk, liquidity risk, prepayment risk, and currency risk. Derivatives are not appropriate for every investor. If you are considering an investment that involves derivatives, you should understand what type of derivative is involved and its specific risk/reward profile.

This information was partially developed by Forefield, Inc., an independent third party. It is general in nature, is not a complete statement of all information necessary for making an investment decision, and is not a recommendation or a solicitation to buy or sell any security. Investments and strategies mentioned may not be suitable for all investors. Past performance may not be indicative of future results. Raymond James & Assoc., Inc. does not provide advice on tax, legal or mortgage issues. These matters should be discussed with an appropriate professional.

Doug Awad is a Financial Advisor for Raymond James & Associates. He will address any questions you have, but can’t guarantee the answers will appear in this column. E-mail your questions to Doug.Awad@ raymondjames.com, or call 854-6866.