Derivatives: Market Friend or Foe? - ZISHI

Derivatives: Market Friend or Foe?

Derivatives – futures, options and swaps – have a problem. Many perceive derivatives as complex, arcane and excessively risky, the preserve of edgy speculators – high-rollers in the global casino.

In reality, derivative contracts were first conceived to facilitate hedging – insurance against adverse price movement:

    • Forward contracts allowed farmers to plan ahead and gain certainty about the prices they would receive for crops at harvest,

    • Put options allowed investors in potentially risky enterprises to protect themselves against things going wrong,

    • Swaps allowed borrowers to fix the rates they would pay by removing the dangers of spikes in interest rates.

Regardless of specific circumstances, derivatives were first designed to reduce or remove risk, in much the same way that insurance helps us in our everyday lives.

How do we view insurance? Is it a good thing or bad? Surely insurance is a good thing, a way to spread risk, to average out the vagaries of good or bad fortune over the longer term.

It’s all about how we use insurance. Most of us buy insurance – we protect ourselves against bad things happening – we mitigate risk. But if we sell insurance then we are taking on risk – receiving a payment in exchange for somebody else’s concerns.

Derivatives are no different. If we use them responsibly –for their “true” purpose – then we reduce uncertainty in our everyday lives and business.

But if we use derivatives irresponsibly – “rolling the dice” and taking on excessive risk – then we not only introduce uncertainty for ourselves, but also potentially for others, in the event that we need to be bailed out.

As a derivatives trader with over 40 years of market experience, it becomes ever more obvious to me that understanding derivatives and how they are properly used is crucial.

Yes, derivatives can be complex. But they certainly don’t need to be.

True, exotic OTC structures traded between financial institutions can appear arcane – opaque even – but such structures are niche and need not concern the vast majority.

Unquestionably, derivatives can offer the potential for excessive risk – but that is a choice and certainly not a necessity.

Armed with the requisite knowledge, derivatives are not just a good thing. They offer great potential benefits to hedgers and speculators alike.

Author: William Beagles, Head of Training | Professional Trader Qualifications & Development, ZISHI

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