Demystifying Derivatives

The financial services industry is one wherein changes happen fast and there is need for coercive regulations to keep up with financial innovation. One such area in the financial arena is that of derivatives - financially engineered products. The Indian markets have just been exposed to this arena with the trading of index futures at the BSE and the NSE. The bureaucratic leviathan responsible for reforms and regulations must face the fact that fears about derivatives have proved unfounded. Risk management has assumed a lot of importance, however, there has also been a lot of apprehension about risk-management instruments. The aim of this writing is to reveal the myth about derivatives and to emphasize the fact that derivatives and other risk management instruments should not be feared but embraced with caution to help firms manage the vicissitudes of the market. The most common myths of derivatives are:

Myth#1 says "Derivatives are new, complex, high-tech financial products created by Wall Street's rocket scientists". The truth is "Derivatives are contracts that are based on or derived from some underlying asset, reference rate, or index. Wall Street's "rocket scientists" are continually creating new, complex, sophisticated financial derivative products. However, those products are all built on a foundation of the four basic types of derivatives : options, futures, forwards and swaps". Derivatives is basically a risk hedging mechanism which by definition is as old as man himself.

Myth#2 says "Derivatives are purely speculative, highly leveraged instruments and are akin to gambling".
The truth is " that the explosive use of financial derivative products in recent years was brought about by three primary forces: more volatile markets, deregulation, and new technologies. Banks and other financial intermediaries responded to the new environment by developing financial risk-management products designed to better control risk".

Myth#3 says "The enormous size of the financial derivatives market dwarfs bank capital, thereby making derivatives trading an unsafe and unsound banking practice". The truth is " that the financial derivatives market's worth is regularly reported as more than $20 trillion. However for derivatives, notional principal is the amount on which interest and other payments are based. Notional principal typically does not change hands; it is simply a quantity used to calculate payments"

Myth#4 says "Only large multinational corporations and large banks have a purpose for using derivatives"
The truth is "Financial derivatives are important tools that can help organizations to meet their specific risk-management objectives and it is important that the user understand the tool's intended function and that the necessary safety precautions be taken before the tool is put to use".

Financial derivatives have changed the face of finance by creating new ways to understand, measure, and manage risks. Ultimately, financial derivatives should be considered part of any firm's risk-management strategy to ensure that value-enhancing investment opportunities are pursued. The freedom to manage risk effectively must not be taken away.

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