GENERAL INTRODUCTION DERIVATIVE INSTRUMENTS

GENERAL INTRODUCTION DERIVATIVE INSTRUMENTS

A possible item of financial fixed assets within the annual financial statements may be formed by derivative financial instruments: in this regard, regardless of the more complex correct accounting and valuation in the financial statements, it is first of all worth clarifying the nature of the same.

A derivative is a financial instrument whose value depends on and is derived from that of another type of asset, called the underlying: a variety of assets, such as stocks, currencies, interest rates, commodities, debt instruments, or less traditional parameters, such as electricity, insurance payments, and weather conditions, can constitute underlyings of a contract.

Derivatives are traded within regulated markets and in over-the-counter (OTC) markets, where bank traders or corporate fund managers and treasurers contact each other directly, without intermediaries, in order to carry out the transaction: of course, trading in regulated markets is in much higher volume than in OTC markets; in 2018 there was about $700 trillion in business volume in the former, compared to less than $100 trillion in the latter.

PURPOSE AND IMPLICATIONS

Derivative instruments have a multiplicity of uses; in fact, they can be used:

as financial risk hedges of the company's commitments;
for speculative purposes, considering forecasts made on market trends;
to lock in arbitrage profits and losses;
to change the nature of a liability, from fix to float and vice versa;
to manage or possibly change the nature of an investment, without incurring the costs of selling the entire portfolio or buying another.

However, while the use of derivative instruments can be beneficial because of the various purposes, it should be remembered how they are very risky instruments, for which one must operate with caution and prudence, as well as thorough prior study. An example in this regard can be provided by the largest bankruptcy in recent history, namely that of Lehman Brothers: the banking institution actively traded in the OTC derivatives markets, finding itself in financial difficulty in this respect as well, having taken high risks and no longer being able to meet such large short-term commitments, thus coming to have thousands of outstanding transactions with roughly 8 thousand counterparties involved. In the subsequent liquidation phase, coping with such transactions was exceedingly difficult, both for Lehman's liquidators themselves and for the institution's counterparties. For this reason, and especially after the financial crisis, it appeared essential that control systems be set up within a company by risk management in order to ensure that traders buy and sell derivative instruments exclusively in relation to the designated objectives, since traders, depending on the purpose of purchase or sale, implement very different operating modes among themselves.

MAIN TYPES OF DERIVATIVES

The most common derivative instruments are futures, forwards, swaps and options:

futures and forwards, give the contracting party the obligation to buy or sell the underlying asset at a given price, at a given predetermined time. The difference between the two types lies in the fact that futures are traded on regulated markets and are therefore standardized in the various contractual postings; in addition, net positions are settled daily: settlement is by the daily margin method in order to minimize the risk of default, thus reducing the possibility of a loss due to default; closing out the position on the futures contract presupposes entering into a contract of the opposite sign. In contrast to what has been stated so far, forward contracts are privately and directly traded by counterparties in OTC markets: for this reason they are not standardized and are normally settled at maturity, thus generating higher credit risk;
swap contracts are private agreements between two or more companies entered into for the purpose of exchanging future cash flows, according to a predefined formula. The most common swaps are those relating to the exchange of cash flows having the nature of interest, calculated on the basis of predefined interest rates, such as Libor or Euribor, or otherwise, and a notional principal amount. The purpose of these instruments is to convert the rate of an asset and/or liability, from a fixed rate to a floating rate and vice versa; as for the credit risk of the swap, it initially has a zero value that undergoes positive and negative trends over time: the company has credit exposure only when the value of the swap is positive;
options give the holder the right, not the obligation, to buy or sell at a specified price the underlying asset, on a specified date. Options are divided into call and put options: the former offer the ability to buy a particular asset by a certain date for a set price, defined as the strike price, while the latter offer the ability to sell it. There is another main distinction regarding options: European options can be exercised only on the expiration date, American options at any time, and Bermudian options exclusively on specified and agreed upon dates. Regarding the general characteristics of options: the underlying assets can be stocks, foreign currencies, stock indices, and futures; and the expiration dates, strike prices, and types of options are specifically contracted.

TERMINOLOGY

Finally, we want to present an overview of the relevant technical terminology.

When a transaction is entered into, the counterparty with the right to buy is referred to as "long on the underlying" or having a "long position," long position, while the counterparty with the obligation and/or right to sell is referred to as "short on the underlying" or having a "short position," short position. Considering the structuring of the contract there are two basic and main parameters to monitor: price and duration. The price is closely related to the time horizon: we talk about forward price, which is the forward price of the contract, as the delivery price at maturity applicable to the contracting party of the contract, if it were traded today; therefore, this forward price differs according to the duration of the same contract. Instead, we speak of spot price as the price a buyer must pay in a transaction of a financial asset whose delivery is immediate, i.e., concurrent with entering into the contract.

When the position is long, there is a profit when the actual price of the underlying asset at maturity is greater than the forward price on delivery, stipulated at the time of the initial stipulation of the contract, vice versa there will be a loss when it is less; on the other hand, considering a short position, there is a profit when the actual price of the underlying asset at maturity is less than the forward price on delivery, stipulated at the initial time of the transaction, vice versa a loss if it is less.

For the contractor, a derivative is called "at the money" when the cash flow is zero, "in the money" when the cash flow is positive, "out of the money" when the cash flow is negative.

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