The Economic Benefits and Risks of Derivatives

Derivatives have often been criticized and labeled as a dangerous product even though they were mainly created for risk management purposes. In this article, I will try to answer the simple question if derivatives are beneficial for the economy as a whole, by introducing the financial product, evaluating the benefits and potential risks, and focusing on their impact on the economy.

What is a derivative?

A derivative is a financial instrument whose value depends on an underlying asset. For example, the value of a call option on a stock will change according to movements of its underlying asset and its price changes. Initially, derivatives were created mainly to manage risk. However,  after some time, they were used excessively for speculation purposes in the market. As of today, the main types of derivatives are options, futures & forwards, and swaps.

Options are contracts that allow the owner of the option to buy or sell a product at a price that is fixed in advance. Let’s say that an option gives its owner the right to buy a Ford Stock at 25 dollars, but the price of the stock today is 20. The option is worthless, since it would only allow the owner to buy the stock at a price higher than the market price. However, if the price of the Ford stock goes to 30, then the option will gain value, since it now allows the owner of the option to buy the stock at a price lower than the market price. Hence, the value of the option is derived from the value of the underlying stock.

Futures and forwards are similar to options, except that they are contracts that give the owner the obligation – not the possibility – to buy or sell the underlying asset at a certain price, fixed in advance, at a certain date. The difference between these two instruments is that futures are more standardized, with generic features, and traded on an exchange, while forwards are instruments negotiated privately between two parties and are rather custom made.  

Swaps are contracts between two parties to exchange cash flows at regular intervals during a certain period. The most common are interest rate swaps, where one party will agree to pay a fixed interest rate to the other party at regular intervals, while at the same time the other party will pay a variable interest rate.

One last concept important to understand before analyzing the benefits and risks of derivatives is the difference between listed derivatives and “Over-the-Counter” (OTC) derivatives. For listed ones, the trades are executed on exchanges. Also involved are so-called clearinghouses, which act as a third actor, sitting between the two parties of the contract. The role of a clearinghouse is to make sure that there is no default from one of the parties involved in the contract. Therefore, as certain requirements are involved in the trade, such as collateral or margin calls, the probability of default of one party is close to zero. On the other hand, derivatives can be traded over-the-counter (OTC), without a clearing house, directly between two parties. In that case, the default risk is much higher, making OTC trades riskier than their counterparts.

Now that we introduced derivatives, let’s have a look at their theoretical benefits, as well as their potential risks.

The theoretical benefits and risks of derivatives

The main benefit of derivatives is that they allow economic agents to manage risk factors, by giving them the possibility to hedge against those financial dangers. In that case, hedging basically means to offset a certain risk. For example, a multinational American company selling products across the world will earn revenue in different currencies. A risk that the company faces is that all these currencies depreciate against the dollar, which could ultimately cause a lower profit. Therefore, the firm can use derivatives to hedge against that risk: By entering futures contracts where it will agree to exchange foreign currencies against dollars at an exchange rate fixed in advance, the company cancels the risk related to changes in currency rates. Pension funds, which are responsible for investing the money of future retirees, often invest on a very long term horizon, meaning that inflation can have an important impact on their investments. Inflation derivatives can allow them to hedge against that. An airline company might fear a future increase in fuel prices that could make it less profitable or lead to an increase in flight tickets. By using futures on oil or on fuel, it can lock the price of the commodity in advance and not take the risk of facing higher prices in the future. But in all these cases, companies hedging against risks also mean that they cannot benefit from a positive scenario, where the price of fuel would be cheaper in the future for example. In the end, derivatives allow hedging against variations of certain products, whether they could be profitable or not to the company, and to transfer risks to someone else.

Another benefit of derivatives is that they enable price discovery. This means that by looking at the value of derivatives such as options or futures, we can infer future cash prices, the spot price of the next days or months. This is an important benefit since decisions of central banks often rely on what will happen in the future. In addition to that, some studies have even shown that options on the S&P 500 reflected better market conditions than the actual spot prices.

Derivatives can also have more liquidity than their underlying asset. Higher liquidity means lower transaction costs. Lower transaction costs can also derive from the fact that trading a future on an index, such as the S&P 500, is cheaper than trading an ETF on the index.

Even though not all above mentioned benefits might not necessarily generate a monetary gain, they do serve the economy advantageous as a whole. Looking back at the example of an airline company that hedges against variations of fuel, it does not benefit financially from buying futures contracts. It actually has to spend money to buy these contracts. However, the fact that it does not have to worry about variations of the price of oil generates utility to the company, since its business is to operate planes and not forecast the price of oil. Additionally, by allowing price discovery, they also reduce uncertainty related to future prices.

However, derivatives can also be subject to counterparty risk. When one party agrees to sell a product at a certain price through a forward contract, it is possible that the second one might not be able to honor the agreement due to financial problems. As explained earlier, normally, clearinghouses make sure that this does not happen but products that are traded over-the-counter are subject to this counterparty risk.

Another danger related to derivatives is their impact on volatility. Derivatives allow to leverage investments; By buying a derivative one can benefit from price variations of the underlying asset without actually owning it. This means that by buying a derivative, it is possible to get a 10% return when the underlying asset return is only 1%, and vice versa. Followingly, due to the fact that leverage allows for higher variations in returns, derivatives can be associated with a higher volatility of the underlying asset.

Another risk linked to derivatives is the illusion of control that comes with them. As explained earlier, derivatives are tools used to manage risk. Therefore, a company or financial institution could think that, after assessing risks properly, buying the correct derivatives to hedge against these risks would allow it to be perfectly safe. However, there are two main problems with that assumption. First of all, it is impossible to perfectly assess risks. Even the best mathematical models in the world can be wrong, since all models rely on assumptions. Consequently, any gap with reality of these assumptions can lead to false results and incorrect predictions. Secondly, even if risks could be assessed properly, it is difficult to hedge perfectly against it. That leads to the question if derivatives have an overall positive impact on the economy.

Impact of derivatives on the Economy

Empirical studies on the U.S. economy show that derivatives can be beneficial to banks and non-financial institutions. The biggest risks that a bank faces are interest rate risk and credit risk. Using derivatives, banks can manage these risks better and benefit from additional protection. With better financial health, banks will be able to lend more, enabling a higher growth of the economy, leading to a positive relationship between bank lending and the use of derivatives.

For non-financial firms, risk management increases expected cash flows, and therefore, the firm value. Empirical studies also show that firms that use derivatives have a lower cost of capital and fewer financial constraints. Firms with a higher value and lower cost of capital will be able to make more productive investments. Followingly, financially strong banks coupled with sound firms will benefit the economy, meaning that derivatives may have a positive impact on the economy. However, there are cases where the opposite was the case, such as in the financial crisis of 2008. 

Credit Default Swaps (CDS) played an important role in that crisis. We can think of this derivative as an insurance policy. When an insurance company insures a house, it will receive a monthly fee from the client. If an accident happens, the insurance company will pay an amount of money to the client. Credit Default Swaps are like an insurance and the risk that the buyer hedges against is a risk of default. Let’s say that an investor owns bonds from a company but for some reason, he thinks that this company might not be able to pay him back. In that case, the investor can buy a CDS on those bonds. The issuer of the Credit Default Swap commits to pay the investor a certain amount of money if the company defaults, but in exchange the investor who owns the CDS must pay a periodic fee.

Like most derivatives, the benefit of a CDS is to hedge against a risk, in that case, the default risk. Before the 2008 crisis happened, several companies issued so-called mortgage bonds that are just like corporate bonds. These securities pay interest regularly to the owner, as compensation of a certain default probability. The problem was that some companies started to issue many of these credit default swaps, because it seemed certain that they would never have to pay anything to the buyer because the underlying of the CDS would only rarely default. This misconception occurred because the underlying assets were all rated with the highest standards by the major rating agencies. However, the risk was not assessed properly and AAA-rated subprime-mortgage-backed securities issued in 2006 were downgraded to junk status after the crisis. When the crisis happened, defaults of these mortgage bonds increased, and companies had to pay each owner of the swaps that it had previously issued. The rest is history: several financial institutions had to be bailed out because their collapse would have caused a worldwide “systemic macro event” with cataclysmic repercussions.

In the end, the question remains whether derivatives are good or bad for the economy. On the one hand, they certainly have many benefits, related to risk management and a better functioning of financial markets. Empirical studies also show that they are positively correlated to economic growth. On the other hand, derivatives were at the heart of the financial crisis even though it can even be argued that derivatives were not the problem but the inappropriate assessment of risk was. Derivatives only allow the transfer of risk but that risk can be underestimated by the actors of financial markets, which in turn can have dramatic consequences. Therefore, it is important not to be under the illusion of control that derivatives can lead to and to take risk assessment models with a healthy grain of salt.

Author : Bilal Ait Aouida

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