Financial Derivatives

A financial derivative is a financial instrument whose value and profits depend on the value of some more basic underlying financial instrument. For example, a stock option is a financial derivative because the value and payoffs of a stock option depend on the value and price movements of the underlying stock. Similarly, an interest rate futures contract is a financial derivative because the value and payoffs of the futures contract depend on the value of an underlying debt instrument, such as a bank deposit or a bond. As a final example, a foreign currency forward contract is a financial derivative because its value and payoffs depend on the value of the underlying currency.

Strictly speaking, a financial derivative is a derivative that is built on an underlying financial instrument. [Page 912]Different types of financial derivatives include primarily financial futures, options, forward contracts, and swap agreements. Financial derivatives are closely related to other types of derivatives, including agricultural, oil, and precious metal derivatives. The similarity extends to the structure of the instruments, the common economic understanding that links all the instruments, and the very similar pricing principles that unite all derivatives. Social and ethical issues surrounding financial derivatives arise because they are extremely powerful financial instruments that can generate very dramatic profits and losses, they are complex and difficult to understand, they are susceptible to misuse as gambling vehicles, and they at least seem to be far removed from economic realities.

Financial derivatives commonly embody very high leverage; that is, the price of a financial derivative is often very sensitive to the price of the underlying financial instrument, or equivalently, a small movement in the price of an underlying financial instrument can cause a very large percentage price movement in a financial derivative built on that instrument. For example, a 1% movement in the price of a stock could easily cause a 10% movement in the price of an option on that stock. This means that an apparently benign position in a financial derivative can suddenly generate very substantial profits or losses. This happens particularly when some sudden event causes a dramatic swing in financial markets. For example, a sudden interest rate rise can cause debt instruments themselves to have a sudden price drop, and debt derivatives will typically respond to the same interest rate shock with a much larger percentage price movement.

Because financial derivatives tend to be complex and difficult to understand, senior management in firms often lacks a full grasp of the financial implications of the derivatives positions the firm holds. Because of the complexity of financial derivatives, top management sometimes leaves oversight of these instruments to specialists. This lack of control has led to some spectacular business disasters involving financial derivatives that even include the ruin of entire firms, and they have often been used as vehicles for irresponsible speculation and gambling. In some spectacular instances, junior derivatives traders have used the firm's resources to place huge bets via financial derivatives, and the resulting losses have resulted in bankruptcy.

To many observers, the world of finance seems divorced from real economic concerns. For example, a share of stock is nothing other than a financial instrument that evidences an ownership interest in a firm. But a share of stock already stands at a considerable conceptual remove from the land, trucks, and equipment to which the share gives partial title. A financial derivative built on that share may seem completely divorced from economic reality. This perception has led some observers to see financial derivatives as being merely instruments of financial speculation and gambling. Perceived in these terms, it is not surprising that some have seen them as socially and ethically undesirable. Thus, some critics have even called for trading bans and for the dissolution of financial derivatives markets.

...