A senior South China Morning Post business reporter looks at derivatives markets There's been a lot of buzz about mainland derivatives markets lately. There were calls for China to develop its markets and the mainland government was preaching caution against too-rapid expansion. The Shanghai Futures Exchange late last month launched a new zinc futures contract, and it is expected to introduce more futures for various fuels, chemicals and metals. Derivatives trading is relatively undeveloped in China compared to the United States or Europe. Why do people want to invest in derivatives, and how do they work? The name derivatives tells you a lot about what they really are. They are financial contracts derived from, or based on, a security or commodity. For example, crude oil futures are financial contracts based on the prices and standards for trading real crude oil. Unlike stocks and bonds, a derivative is usually a contract rather than an asset. This means you buy or sell a promise to change ownership of the asset, rather than the asset itself. The most common types of derivatives are futures, options, warrants and convertible bonds. Derivatives allow you to take on more or less risk, depending on what you want, and they allow you to do so at lower prices than buying the underlying asset. For example, for an investor who wants to benefit from rising oil prices, it is much easier and more cost-effective to buy oil futures or options rather than buy actual barrels of oil that they will then have to ship and store somewhere. Buying an option to buy 100 barrels of oil is also much cheaper than buying actual oil, since you are paying for the right to buy oil at a certain price at a future date instead of paying for that amount of oil. Their relatively low cost is one reason why derivatives are popular hedging tools. If I own 100 barrels of oil as an oil producer or someone who needs to stockpile oil, I will be hurt financially if oil prices drop. Therefore, I buy 100 barrels worth of put options (see sidebar) to hedge that long position. Derivatives have offered me an economical way to hedge my market position. Derivatives are also economical tools for market speculation. Buying S&P 500 futures is an easy way to bet on the direction of US stock markets. Their role in some spectacular market crashes and investment losses in the past have given derivatives a bad name in many circles. They can be dangerous since they allow an investor to take a very large position in a market without spending a lot of money, and they can raise risk levels sharply if the investor doesn't fully understand how they work. BUSINESS TALK Short selling : A short seller is making a bet that the price of whatever he is selling will go down. He sells it today at a higher price, then buys it tomorrow at a lower price, and pockets the difference. The investor does not own the security he is selling but has borrowed it, and must repay the owner at a later date. Long position : A position that grows in value if the market rises, such as stocks held in a brokerage account. Hedging : Reducing your exposure to risks, such as changing market directions, interest rates or currency rates, by taking an opposite position to the one you already have a related market. Derivatives are common hedging tools. Investors often try to hedge against inflation by buying assets, such as gold or real estate. Futures : Futures contracts are forward contracts, meaning they represent a pledge to make a certain transaction at a future date and at a certain price. The contracts are standardised and tradable on an exchange. Options : An option contract describes a sale of a security or commodity that will occur at a later date and at a specified price. However, the sale only occurs if the prospective buyer or the prospective seller wants to go ahead with the sale. If the contract is a 'call option', the buyer has the right to decide whether or not the sale happens; if the contract is a 'put option', the seller decides. The sale price in the contract is called a strike price or exercise price. Warrants : This gives the owner the right to buy a specified amount of stock at a future date at a specified price, usually one higher than current market price. Warrants are like call options, but with much longer time spans. And warrants are offered by corporations, while exchange-traded call options are not issued by firms. Corporations often bundle warrants with another class of security to enhance the marketability of the other class. Convertible bond : A type of bond that can be converted into shares of stock in the issuing company. While the bonds don't pay a high interest rate, the holder of the bonds usually benefits from converting the bond to common stock at a substantial premium to the stock's market value.
