Derivative securities

In their basic form, derivative securities are agreements between two or more parties. The parties agree to pay each other based on some agreed benchmark. For example, two businesses agree to pay each other based on the behavior of INTEREST RATES. If interest rates rise above a previously agreed level, one company pays the other. On the other hand, if the interest rates fall below the agreed level, the other company pays the first. The amount that each company must pay is derived by the terms of the agreement, hence the name derivatives. Usually the higher the rate goes above the benchmark rate, the more one company must pay the other, and vice versa. This is similar to betting on a football game where the bet varies based on the difference in scores. To complicate things even more, the agreement can specify the way that payment is made—in currency; securities; or a physical commodity such as gold, silver, corn, or pork bellies (used to make bacon). Although derivative securities are nothing more than complicated gambling, they can serve a useful business purpose. To illustrate, suppose a resort hotel negotiates a CONTRACT with a Japanese tour operator, who wants to have the contract stipulate payment in yen. This protects the tour operator if the value of yen falls. The operator is charging his customers so many yen to come on the tour. If the value of yen falls and the hotel rooms were priced in dollars, the tour operator would lose. To avoid this risk, the tour operator forces the RISK onto the hotel. To get the tour operator’s business, the hotel must accept payment in yen, but it does not want the risk of the yen falling in value, because when it exchanges the yen into dollars, it gets fewer dollars than it bargained for. On the other hand, the hotel could make an unexpected profit if the yen increased in value. To shift this risk, in essence it sells to someone else by using a derivative. The derivative contract specifies that the hotel will pay if the value of the yen increase, but if it falls the other party pays the hotel. They are essentially betting on the change in the yen EXCHANGE RATE. The hotel puts the agreement together in such a way that the derivative contract will produce profits that make up for the amount it loses on the yen deal with the tour operator. If the hotel should make money on the agreement with the tour operator because the yen went up in value, it would lose a corresponding amount on the derivative arrangement. This effectively shifts the risk of the fluctuating yen to the other party to the agreement.
See also FUTURES; HEDGING.