Tools of a fund expert's trade

PUBLISHED : Sunday, 14 July, 1996, 12:00am
UPDATED : Sunday, 14 July, 1996, 12:00am

RISK is an issue at the heart of every investment decision and is of vital importance in international investment.

Depending on the value of an investment, risk can be managed using derivatives products either directly or through an intermediary such as a fund manager.

A derivative, for example a futures contract or an option, is a deal based on a payment between parties related to movement in the price or level of an underlying security, future or financial index.

The term has become associated with financial instruments but historically its roots were in farming - the first formal futures contracts were created for US farmers seeking to fix a future price for their crops of onions and potatoes.

Futures trading floors are impressive for their hi-tech communications systems and traders in bright clothes, but the concept of the market is the same whether the contract traded is related to vegetables or the Nikkei stock index; someone is trying to lock in a future price and someone on the other side of the deal is happy to take a counter-posing risk.

Derivatives are instruments whose value is derived from something else.

An option gives the holder the right to buy or sell the underlying instrument, index or commodity at a predetermined price before a fixed expiry date.

A swap is an exchange of obligations, usually related to currencies and interest rates.

A forward contract is a deal to buy or sell something, often a currency at a fixed time in the future at a predetermined price.

A warrant is a kind of long-dated option. In Hong Kong, a common application is the covered warrant issued either by the company which issues the underlying stock or a third party, often an investment bank.

All these instruments have the common characteristic of being risk transferal mechanisms.

All can be traded by speculators seeking short term gains or by investors seeking an alternative exposure or insurance from another position.

One common feature of derivatives is that their value is determined by the price of one or more underlying instruments or markets.

Examples of derivatives in common use today include futures, options and warrants with their values linked to underlying stocks, commodities, interest and foreign exchange rates and market indices.

A derivative is a contract which usually does not involve delivery, but some kind of financial settlement.

Derivatives have become associated with financial disasters because of high profile incidents such as the collapse of Barings and big losses by US corporates, including firms like Procter & Gamble.

The main reason these instruments were invented was to provide a hedge to investors' exposures in physical markets.

They can be used to hedge positions and lock in rates of return or interest payable on a loan.

Because they are typically contracts between two parties, derivatives can involve an element of counterparty risk; that is, that the bank or other party to a swap or other derivative deal might not be able to deliver on their obligation.