Financial instruments: from the traditional to the more complex

Derivatives: seeking to reduce uncertainty

Derivatives are financial instruments whose value usually depends, or derives, from another financial instrument, indicator or commodity. The term covers a wide range of financial instruments which are used for a number of purposes, including risk management, hedging and arbitrage.

While derivatives may sound new and unusual, they have existed in various forms for a long time. Uncertainty about future events which may have an impact on individual or collective wealth gave rise to the creation of contracts designed to remove or reduce the uncertainty of the delivery of or payment for a product. A first record of a contract of this kind dates back to Mesopotamian times, where a supplier of wood promised to deliver thirty wooden planks to a client at a future date. For the buyer, the deal increased their certainty about getting the planks when needed, while the seller got an earlier payment.

Over time, these contracts have been formalized and refined and there is now a wide range of instruments, with their own characteristics and purpose. While they may have originally been intended to reduce certain risks, they may carry significant investment risks, as their complex nature typically lends them to be used primarily by institutional or professional investors:

Forwards

The simplest and oldest form of derivatives. A forward contract is an agreement to sell something at a future date at a price decided in the present, just like the wooden planks example. Today, forward contracts still take place between two counterparties, meaning that no exchanges or intermediaries are involved

Futures

Similar to a forward contract as it is an agreement to sell something at a future date at a price set today, but the difference is that futures are listed on an exchange. The exchange becomes an intermediary in the transaction, defines the terms of the contracts and the two counterparties do not enter in an agreement with each other

Options

An option contract binds one party to buy or sell at a specific date and at a preset price, but it allows the other party to decide at a later day when to execute it (and they pay a premium for that privilege). There are two types of options: call options (the right but not the obligation to buy something at a later date at a given price) and put options (the right but not the obligation to sell something at a later date at a given price). Options are also traded on exchanges

Swaps

The most complex of all the derivatives, as it covers cash flow streams and not physical things such as wooden planks. The most common example is a swap of an uncertain cash flows (e.g. the income of a variable interest rate instrument) for a certain cash flow (e.g. the income of a fixed interest rate instrument). Swaps are private contracts and not usually traded on exchanges

Derivatives are more complex instruments and are sometimes used to hedge against market fluctuations and uncertainty. They aim to transfer risks from entities less willing or able to manage those risk, to entities more willing or more able to do so.

They are used by a variety of financial market participants, as well as others, for example:

• Agricultural companies that may want to set prices for future crops or livestock using futures contracts
• Export companies that may use swaps to achieve certainty of future foreign revenues
• Pension funds that may use options to manage interest rate risks and protect pension pots

Structured products: a growing area

After being introduced in the UK in the 1990s, structured products have gained more traction worldwide over the last decade. They are a broad and complex set of investment instruments, delivering a return dependent on the performance of underlying asset(s).

Structured products may be used by investors seeking to tap into certain characteristics of derivatives. They may also be designed around specific needs and market conditions.

The payoff of a structured product will usually follow a contingency-based structure. Returns will be dependent on the achievement of certain conditions or the performance of an underlying component.

Structured products have several components, and each play a specific function:

• 

  Bond

  Or another type of financial instrument that generates an interest payment. Both can be used to pay for the derivative and/or serve to protect capital.

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  Underlying component

  Can be a reference asset (single equities or corporate bonds), a market measure (index levels) or even currencies and interest rates.

• 

  Derivative

  Usually an option. It shapes the return or payoff of the structured product. The choice of derivatives will depend on the desired risk level, the investment horizon, the type of return and exposure sought and current market conditions.

When investing in a structured product, investors are effectively buying a bundle of different components, and the total price will reflect the price of the individual instruments.

Investors may use structured products in a variety of ways:

• Express a market view
• Provide some level of capital protection
• Complement an existing investment objective and portfolio
• Hedge an existing position
• Gain exposure to the underlying financial instruments, which can be equities, fixed income or even currencies

In 2022, more than $1tr of new structured products were issued globally³.

¹ SIMFA 2023 Capital Markets Fact Book

² Growth in Bond Mutual Funds: See the Whole Picture | Investment Company Institute (ici.org)

³ Acuity “Global Structure Finance, 2023 outlook”