Financial Derivatives

With nearly $700 trillion in notional value – over seven times the market capitalisation of global stocks or over five times global GDP – the sheer volume of Financial Derivatives dwarfs any other forms of financial instrument. In this blog, derivatives expert Philippe Dufournier reflects on the challenges and opportunities presented by these mechanisms.

By definition, Financial Derivatives are a contract by which two parties agree to exchange in the future (i) cash flows or assets (ii) the values of which are indexed to changes in financial variables such as foreign exchange, interest rates, commodities, equity and credit and (iii) at terms agreed upon today. Contracts are bilateral, confidential in nature and involve either two private parties in what is called the Over-the-Counter (OTC) market or a private party and a Derivatives Exchange, in the case of an exchange-traded contract.

Ubiquity is another key attribute of Derivatives, as they enable many financial transactions, both in the business and the retail world. These include:

• Pre-payable mortgages without penalty
• Capital guaranteed equity investment products
• Convertible bonds, forward purchases of crude oil
• Options to exchange fixed amounts of dollars and euros in 5 years.

At their core, Financial Derivatives enable Party A to transfer to Party B, over a chosen period of time, certain specific market risks it does not wish to keep. In this case, it is also an opportunity for Party B to gain exposure to the risk in question. For example, if a large Telecommunication company borrows money from banks via a 3yr Loan whose rate of interest is Euribor 3 Month + 1%, it may want to eliminate the risk of fluctuation of Euribor by swapping with another bank the quarterly settings of the floating index for a fixed rate over the 3 years of the loan. In that way, it has transferred the floating rate risk to the market and manufactured a synthetic fixed rate Loan. Note that this is achieved without altering the terms of the initial loan agreement.

There are multiple participants to the derivatives markets in the pursuit of different objectives. Investment banks and market-making securities firms are frequent users to provide liquidity to so-called end-users. Participants include:

• Asset Managers wanting to reduce the risk of a decline in the equity markets or the risk of rising interest rates by respectively selling equity futures contracts and entering into fix paying swaps
• Corporates wishing to manage their PnL exposure to Foreign Exchange fluctuations by using FX forwards and FX options
• Banks aiming to protect the credit risk embedded in their loan portfolio using credit default swaps or looking to tailor the risk exposure they want to include in retail investment products vis equity options
• Hedge Funds looking to source tail-risk exposure to produce returns for investors

In their OTC format, derivatives are limitless in scope and flexibility. Agreements can extend to 30 years or more, payments may refer not just to changes in FX rates or to the S&P but also, for example, to extreme weather events, to relative changes in inflation between two currencies, or to the combination of multiple market events happening at once. Because of their inherent leverage and their relative complexity, derivatives have been seen in the recent past as potentially ‘toxic’ for the financial system. They were infamously the so-called ‘weapons of mass destruction’ of the great financial crisis of 2008. 15 years on however, financial regulators, exchanges, clearing houses and banks have worked hard and gone a long way to make derivatives a transparent, well capitalised and risk-controlled market place.

The author Philippe Dufournier is IFT Industrial Professor. Find out more about our Industrial Professors here.