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Derivation of danger

Why are some of the most useful inventions on the planet also some of the most dangerous? Electricity, for example. All of us would struggle to live without it but we realise that it must be treated with respect. If it is not, beware the consequences.

Derivatives fall into the same category. Used properly by competent individuals they can be very useful financial management tools. Used by the unwary they can be lethal.

Early use of derivatives was in relation to crop production in America. Farmers who wanted to ensure that they could get a certain price for their crop would sell them forward. In doing so, they were committing to sell a certain quantity of the produce on a certain date to a specific buyer at a predetermined price.

The benefit to the farmer was that he was guaranteed a certain price and could therefore be sure he would have a financially viable year. But there was a downside. Because the farmer had committed to a price in advance he would not benefit if the produce was scarce and the actual market price at harvest was higher. The farmer had given away his upside potential to protect himself against his downside risk.

The purchaser of the produce had also traded his risk for stability. In his case, it was being protected against the risk of a poor harvest resulting in high prices. To remove risk, he had lost the chance that he would be able to obtain the produce at a low price.

Over the course of a growing season, farmers found that the price at which they could agree to sell their produce at harvest time moved. This arose from varying demand and varying expectations about the success of the forthcoming harvest.

For example, if there were concerns that a poor harvest was likely, this would indicate higher ultimate selling prices and so raise the price at which farmers could agree to deal at in the future. Over time, a secondary market arose, with traders dealing in the forward contracts rather than in the produce itself. At that point, the derivatives market was born.

Derivatives which involve obligation are not the only type.

In financial options, the two basic building blocks are the put option and the call option.

The buyer of a put option is buying the right to sell a particular security at a particular price on a particular date or during a particular period. Note that it is an option rather than an obligation. The security is usually a share of a basket of shares representing an index.

Put options allow the investor to limit the loss on a stock or portfolio. Holders of put options have bought the right to sell their security if its value drops below the agreed price. If the price or index level drops below this strike position the holder will exercise the option and sell at the strike position.

For example, an investor in FTSE 100 stocks might be aware that he will become insolvent if the market falls below a certain level, say, 4,000. To protect himself, he may buy a FTSE 100 put option with a strike level of 4,000.

If the market does not fall below 4,000 during the lifetime of the option he is happy as he has remained solvent. If it does fall below 4,000 then he can exercise the option at 4,000 and remain solvent.

There is a price for this protection and the investor must judge the value of the protection gained relative to the price.

The price will vary by the length of the contact, the type of option (American options can be exercised at any time during the term, European can only be exercised at the end), the strike level at which the option applies, the current level of the market and the level of stability of the market. All these features affect the price because they affect the level of protection given.

To give an example of how put options can vary in price, the price of an American three-month FTSE 100 put at 4,000 would have been 0.01 per cent (of amount to be protected) on June 1, 2001. By October 1 this had risen to over 0.45 per cent.

The seller of a put option is acting in the role of “insurer”. In return for a fee, he is looking at the risk that the option is exercised and he is obliged by the holder of the put option to pay more for the assets than they are worth.

For example, the seller of a FTSE 100 put at 4,000 will be heavily exposed if the stockmarket falls to 3,000.

Call options are similar to put options except that they give the holder the right to buy (rather than sell) securities at a certain price.

In life insurance, options can be used in several ways but one obvious way is to match the value of assets to the pay-off profile for capital guaranteed products. Given recent dramatic falls in stockmarket values, institutions which have purchased such protection may be breathing a sigh of relief.


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