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the underlying instrument (most notably, its cur- rent price and price volatility).

Forwards and options are the basic derivatives, but more complicated products can be created by putting together these basic pieces like Legos. A swap, for instance, is eectively a bundle of for- ward contracts. Contracts can be created with various option features, and more complicated options, such as options that depend on the path of the underlying price over time rather than at a single point in time are also quite common.

Derivatives are Janus-like, because they can be used for very dierent purposes. Indeed, these purposes sometimes seem antithetical, but they are in fact symbiotic. For instance, derivatives can be used to reduce risk exposure, that is, to hedge. A natural gas producer concerned that a fall in the price of gas to $3/MMBtu might render him unable to re- pay debt to his bank might sell a forward contract on natural gas for delivery at the prevailing market price of $4/MMBtu. If the price of gas indeed falls to $3, the producer receives a prot of $1/MMBtu on his forward contract (he sold at $4 and can re- purchase it for $3), which, when added to the $3 he gets when he sells his gas, generates a cash ow of $4/MMBtu that is sucient to meet his debt.

In the above example, to get adequate protection, the producer foregoes the upside; if the price of gas were to rise to $6, for instance, the producer would lose $2 on his forward sale, leaving him with a $4 net. at is, a forward contract hedger protects on the downside by giving up the upside, and eectively locks in a price of $4—the prevail- ing forward price in the market. Alternatively, the producer could buy a put option that gives him the right (but not the obligation) to sell gas at $4/MMBtu. is would put a oor on the price that the producer receives equal to $4 minus the price paid for the put; unlike with a forward sale, however, the put purchase allows the producer to prot from price increases.

Although derivatives can be used for hedging, they can also be used for speculation. If I believe that the price of oil is going to rise, I can buy an oil forward contract. If I am right, and the price of oil exceeds the forward price I locked in, I make money. If I am wrong, and the price of oil falls, I lose money. erefore, whereas a hedger trades derivatives to reduce risk exposure, a speculator willingly adds to risk exposure.

  • ere is a common tendency to treat hedging as

a virtuous use of derivatives markets and specu- lation as a vice akin to gambling. But, in this in- stance, virtue and vice are codependents. e hedger needs somebody to take the opposite side of his trade: a buyer (seller) if he is a seller (buyer). Perhaps there is another hedger with a mutually coincident need, in which case hedger can trade with hedger. But at any instant of time, and even over longer time periods, the buying hedging and selling hedging interests need not exactly oset. For instance, more rms may want to sell forward as a hedge than wish to purchase at a price that re-

  • ects the expected value of the underlying at the

derivative’s expiration date. is would tend to depress the forward price, which provides a prot opportunity to a speculator willing to bear the as- sociated risk. us, speculators facilitate hedging by taking on the risk that hedgers wish to shed.

Put dierently, derivatives markets are risk trans- fer markets. ey facilitate the transfer of risk from those exposed to it but who do not wish to bear it (hedgers) to others not naturally exposed to it but willing to bear it (speculators). Trades between speculators and hedgers are transactions between consenting adults who wish to transfer risk at a mutually benecial price.

Derivatives are traded in a variety of ways. Some derivatives are traded on organized exchanges, such as the Chicago Mercantile Exchange or Eurex. For instance, forward contracts—typically called “futures” contracts”—are traded on both




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