Derivatives - the basics

Head of Foreign Exchange and Emerging Markets Quant at Morgan Stanley, explains derivatives
Investment banking
Types of work

University College London****recently held its inaugural Financial Markets Conference. It was organised by a team from the university's Augustus De Morgan Maths Society. Over 150 students came to watch presentations from senior representatives from some of the world's largest financial institutions. The idea was to give an insight into the various products and roles that make up the financial markets. In this extract from his presentation Dr. Jamie Walton, Head of Foreign Exchange and Emerging Markets Quant at Morgan Stanley, explains what a derivative is.

The main asset classes are equities, interest rates, foreign exchange, commodities and credit.

A derivative is any product whose value is dependent on one or more underlying asset. Two common types of derivatives are forwards and options.

A forward allows you to buy or sell an underlying asset at a future date at a level determined today.

Futures are similar to forwards except that they are traded on exchanges (forwards are traded over the counter) and an investor needs to post margins regularly.

An option is the right to buy or sell the underlying asset at a fixed price on a given future date. An option to buy the underlying asset is called a call option and the option to sell it is called a put option. As the option is a right and not an obligation, it is only exercised if it has positive value (we say it is "in-the-money").

Hedging is a strategy in which by use of derivatives a party can reduce its risk. An investor engages in transactions that will counterbalance his position on another trade, thus ensuring a certain profit or minimising losses.

Speculation: Derivatives can also be used to increase risk and generate higher returns. An investor may choose to buy or sell derivatives depending upon whether they expect the value of the underlying asset to rise or fall. This involves speculating on the future movement of markets. Speculation is a popular strategy because the profits can be greater and the losses more limited than if the investor held the asset itself.

Arbitrage: An arbitrage opportunity exists where there is a discrepancy in the markets, which means the investor has the chance to make a profit but is guaranteed not to make a loss. There might be a discrepancy between the current value of an asset and its true value. If a market has a significant number of players (i.e. is highly liquid), then such opportunities cease to exist as the present value is pushed towards the true value of the asset.

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