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2181-3906
2023
International scientific journal
«MODERN SCIENCE АND RESEARCH»
VOLUME 2 / ISSUE 10 / UIF:8.2 / MODERNSCIENCE.UZ
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UNDERSTANDING DERIVATIVES: ASSOCIATED RISKS AND
POTENTIAL REWARDS
Jahongir Yuldashev
Banking and Finance Academy of the Republic of Uzbekistan
Khоlikоv Khamidulla
Hеad spеcialist, thе Cеntral Bank оf thе Rеpublic оf Uzbеkistan
khamidullakhоlikоv@gmail.cоm
https://doi.org/10.5281/zenodo.10013748
Abstract.
The primary objective of this article is to provide a comprehensive understanding
of derivatives, highlighting their significance in financial markets and the diverse strategies
utilized to mitigate risks for both businesses and investors. In addition, the article will dive into
the history of its evolution and possible hazards linked to these complex financial instruments.
Key words:
financial derivatives, Code of Hammurabi, Aristotle’s Politics, Osaka rice
exchange, futures contract, forward contract, option, swap, hedging, risk management, hedger,
arbitrageur, speculator, commodity risk, exchange rate risk, credit risk, credit default swap.
ПОНИМАНИЕ ПРОИЗВОДНЫХ ФИНАНСОВ: СВЯЗАННЫЕ РИСКИ И
ПОТЕНЦИАЛЬНЫЕ НАГРАДЫ
Аннотация.
Основная цель этой статьи — дать всестороннее представление о
деривативах, подчеркнув их значение на финансовых рынках и разнообразные стратегии,
используемые для снижения рисков как для бизнеса, так и для инвесторов. Кроме того, в
статье будет рассмотрена история его развития и возможные опасности, связанные с
этими сложными финансовыми инструментами.
Ключевые слова:
производные финансовые инструменты, Кодекс Хаммурапи,
Политика Аристотеля, Осакская рисовая биржа, фьючерсный контракт, форвардный
контракт, опцион, своп, хеджирование, управление рисками, хеджер, арбитражер,
спекулянт, товарный риск, валютный риск, кредитный риск, кредитно-дефолтный своп.
INTRODUCTION
Financial derivatives are a classification of financial instruments that derive their value
from an underlying asset or a collection of assets. These instruments cover a broad spectrum of
financial products that serve various purposes and cater to diverse needs in the market.
Financial derivatives provide protection against potential losses and are utilized as a
powerful tool to effectively handle and mitigate risks, while also allowing individuals and entities
to participate in speculation activities related to price fluctuations.
Given the interdependent nature of the modern global economy, financial derivatives
assume a pivotal role in facilitating the operation of financial markets. In the finance sector,
possessing a profound understanding of financial derivatives is of utmost significance, particularly
for individuals aspiring to embark on investment or pursue a professional path in this domain.
LITERATURE REVIEW
Historical background
First derivatives can be traced back to ancient Mesopotamia nearly 3,800 years ago. Their
most primitive form was mentioned in the Code of Hammurabi
[1]
, one of the earliest written legal
ISSN:
2181-3906
2023
International scientific journal
«MODERN SCIENCE АND RESEARCH»
VOLUME 2 / ISSUE 10 / UIF:8.2 / MODERNSCIENCE.UZ
545
documents in the history of human civilization. The code consisted of a comprehensive set of 282
laws that established guidelines for conducting commercial activities and stipulated penalties and
sanctions to ensure justice. The significance of the code during that era can be seen through its role
in providing a legal structure for business dealings, governing the behavior of merchants and
establishing guidelines for settling conflicts between traders
[2] [3]
.
The 48
th
law of the code proclaimed that “If any one owe a debt for a loan, and a storm
prostrates the grain, or the harvest fail, or the grain does not grow for lack of water; in that year he
need not give his creditor any grain, he washes his debt-tablet in water and pays no rent for the
year”
[4]
.
It appears that during that time, a regular farmer would have a loan on his land and was
obligated to make annual interest payments in the form of grain. In the event of crop failure, the
farmer had the option to forgo interest payments and the lender had no alternative but to accept it.
Experts in the field of derivatives would classify this agreement as a put option
[4]
.
A subsequent indication of derivatives in historical records can be traced back to Aristotle’s
Politics. Aristotle mentions Thales, a philosopher and mathematician from Miletus, who made a
remarkable prediction about an abundant olive harvest by carefully observing the winter sky.
Thales took advantage of this by engaging in negotiations with the owners of the olive presses, in
order to secure the right, but not the obligation, of renting all of the olive presses in the region for
the upcoming autumn season. As predicted, the harvest turned out to be bountiful, which led to an
increase in demand for the use of olive presses. Today, professionals would categorize this
particular financial instrument as a call option
[4]
.
The earliest documented evidence of a structured marketplace for exchanging derivatives
can be traced back to the 17
th
century in Osaka. During this time, Osaka became the primary trading
center for rice in Japan. Rice played a significant role in the economy, with shipments coming
from all over the country and being stored in Osaka. The rice was then sold through auctions, and
after a deal was made, sellers would issue a certificate of title for the rice in exchange for money.
Merchants had the option to hold onto the bills or sell them, hoping to make a quick profit within
a specific timeframe preceding the delivery of rice. However, as the market evolved, the delivery
dates were extended. The rice bills represented the right to receive a predetermined quantity of rice
at a future date but at the current price, making them comparable to modern-day forward contracts
[1]
.
Categorization of financial derivatives
In the present day, investors intending to acquire a derivative contract may find themselves
overwhelmed by the extensive array of options available to them. There exist hundreds of different
types of derivative instruments, making it initially appear intimidating and perplexing.
Nonetheless, such variations of derivative instruments can ultimately be categorized into one of
four distinct groups.
Forward contracts
Forward contracts are considered to be the most basic form of derivatives in the financial
market. In essence, a forward contract can be defined as a contractual arrangement that involves
the commitment to sell a certain item or asset at a predetermined time in the future. The specific
value at which this exchange will occur is determined at the current time
[5]
.
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A forward contract is executed between two counterparties, without the involvement of an
intermediary, thus amplifying the likelihood of counterparty credit risk. It is imperative to
acknowledge that if these contracts need to be terminated prematurely, the terms may not be
favorable, as both parties have only one option, which is to negotiate with the other party. The
specifics of the forward contracts are confidential information for both parties involved, and there
is no obligation to disclose this information to the general public
[5]
.
Futures contracts
A futures contract shares numerous similarities with a forward contract. These similarities
can be attributed to the fact that both contracts entail the obligation to sell a specific asset at a
predetermined price at a later date. Nevertheless, futures contracts are specifically traded on the
exchange platform, which implies the involvement of an intermediary in the transaction process
[6]
.
These contracts are standardized, and the terms of the agreement are non-negotiable.
Futures contracts are available in predetermined formats, sizes and expirations. Furthermore, due
to their association with the exchange, these contracts abide by a daily settlement procedure,
obligating any profits or losses incurred in a given day to be resolved on the same day. This practice
aims to eliminate the potential counterparty credit risk commonly associated with such transactions
[6]
.
Options
The third category of financial derivatives bear a significant difference in comparison with
the preceding categories. In forward and futures contracts, both parties were contractually obliged
to execute a certain action (buying or selling an underlying asset) on a predetermined date. When
it comes to option contracts, one party assumes the obligation of buying or selling an asset, whereas
the other party is given the freedom to choose whether to buy or sell. Consequently, the party
making the choice is required to pay a premium for this privilege
[6]
.
Swaps
Swaps are likely the most intricate financial instruments within the derivatives market.
They allow individuals to exchange their cash flow streams. For instance, at a later time, one party
may exchange an uncertain cash flow for a guaranteed one, with the most common scenario being
the exchange of a fixed interest rate for a floating one. Parties may also choose to swap the
underlying currency
[5]
.
Swap contracts offer companies the advantage of mitigating various risks, including
foreign exchange risks. Unlike exchange-traded contracts, swap contracts are typically conducted
privately between two parties, usually with the involvement of investment bankers as
intermediaries
[5]
.
Importance of financial derivatives and their primary users
Derivatives are important as they can provide reassurance to individuals who find
uncertainty unfavorable, such as a farmer who relies on weather conditions for their crops and
profits. Although derivatives cannot alter the weather itself, they are capable of altering the
financial consequences of a drought.
Apart from the weather, companies face the risk of fluctuations in commodity prices,
exchange rates and interest rates. The prices of essential resources in the production cycle, such as
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2181-3906
2023
International scientific journal
«MODERN SCIENCE АND RESEARCH»
VOLUME 2 / ISSUE 10 / UIF:8.2 / MODERNSCIENCE.UZ
547
crude oil or copper, change on a daily basis, making future expenses and revenues unpredictable.
Financial derivatives provide companies with the option to minimize their vulnerability to
unforeseen fluctuations in the markets for essential commodities and raw materials
[7]
.
There are three different types of traders in derivatives markets, each having their own
interests, specific roles and strategies, unique market perspectives, different levels of financial
risks and varying degrees of tolerance towards risks: hedgers, arbitrageurs and speculators
[6]
.
Hedgers are individuals or organizations who participate in hedging transactions in order
to reduce potential risks related to their business or investment endeavors. These risks may include
being exposed to unpredictable commodity prices, fluctuating interest rates or unstable exchange
rates
[8]
.
Arbitrageurs are individuals or entities that implement an arbitrage approach with the
intention of capitalizing on a disparity between a derivative and its underlying asset, which could
include commodities, currencies, interest rates or securities. This disparity arises when there is a
difference in value of the derivative and its underlying asset
[9]
.
Speculators participate in speculative transactions with the intention of earning profits by
leveraging market price fluctuations. Unlike hedging or arbitrage transactions, where investors
aim to mitigate risks or exploit price disparities, speculators purposely assume opposing positions
to these transactions
[10]
.
RESEARCH METHODOLOGY
The selection of the research methodology for this article was based on careful
consideration of multiple factors. These factors encompassed the primary question of the study,
the availability of analogous academic papers exploring the similar topic and the necessary data
required for the research.
To obtain the required information, a secondary data collection method was adopted for
the study. This specific method facilitated the swift collection of readily available materials and
information from diverse sources on the internet. The abundance of previously conducted studies
in this particular area contributed to the ease of accessing such data.
The author acknowledged the significance of employing a combination of qualitative and
quantitative approaches in analyzing the data, ultimately ensuring that the research outcomes are
meaningful and robust.
ANALYSIS AND FINDINGS
Businesses and individual investors rely on financial derivatives as instruments to increase
or decrease their exposure to three prevalent categories of risk, namely commodity risk, exchange
rate risk and credit risk.
Exposure to commodity risk
A company that is required to purchase a particular commodity at a later date faces the
potential danger of a sudden upsurge in the cost of that commodity. To mitigate this risk, the
company may employ a widely used derivative instrument known as a futures contract. Such a
contract assists the company in minimizing its vulnerability to fluctuations in the prices of the
commodity in question.
When a company purchases a commodity futures contract, it commits to a specific price
that it will pay for the acquisition of that commodity at a later point in time. Subsequently, the
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individual who sells the contract is bound to deliver the specified commodity on a predetermined
future date, adhering to the agreed-upon price. This future timeframe may span from several
months to several years.
A case of JSC “Kvarts” could be deployed as an example to demonstrate the practical
application of financial derivatives for hedging commodity risk. Established in 1975, JSC “Kvarts”
is one of the leading companies in Central Asia that specializes in the production of colored, tinted
and tempered glass, alongside glass jars and bottles. Company uses quartz sand as a main
ingredient for the manufacturing of products and its profitability is significantly influenced by the
fluctuations in the market value of this essential resource
[11]
.
The average price for quartz sand in October 2023 stands at 276,545 sums per ton
[12]
. At
this point, JSC “Kvarts” has the option to secure this October 2023 price or alternatively take a
risk by speculating that prices might decrease in the future. However, if the company’s prediction
proves to be inaccurate and the prices unexpectedly rise beyond 276,545 sums, it could potentially
damage the company’s earnings or compel them to raise prices for their products.
JSC “Kvarts” mitigates commodity risk by acquiring a futures contract, thereby redirecting
attention towards their core business of producing glass products, while alleviating concerns over
fluctuating raw material prices. Conversely, the quartz sand producer secures a fixed price for their
product by selling the futures, safeguarding against potential declines in market prices in the future.
Exposure to exchange rate risk
Exchange rate risk occurs when a company engages in international trade by either
exporting or importing goods and services, and the value of its domestic currency fluctuates in
relation to foreign currencies. To address and mitigate these risks, a company may employ forward
contracts or currency options as effective mechanisms in safeguarding against potential
unfavorable movements in exchange rates.
A currency option grants a business the choice, without imposing any obligation, to
purchase or sell a specific currency at a later date, using a pre-defined exchange rate. On the other
hand, the counterparty involved in this transaction assumes the obligation to either buy or sell the
specified currency at a predetermined date and exchange rate. In return for undertaking this
obligation, the counterparty receives a certain sum of money known as premium.
To illustrate the application of financial derivatives in mitigating foreign exchange rate
risk, we can delve into the theoretical case of JSC “UzAuto Motors”, a state-owned automotive
manufacturer in Uzbekistan. The company specializes in the production and distribution of
passenger cars and ultra-small minibuses under the Chevrolet brand
[13]
.
Semiconductors play a crucial role in the manufacturing process of automobiles, serving
as one of the vital components. Every vehicle produced by the company incorporates a range of
100 to 300 various components that rely on semiconductors. These semiconductors are sourced
from a network of 38 international suppliers, meeting the demand for 67 distinct components
across the company’s entire product lineup
[14]
.
After analyzing the fluctuations in the value of the Uzbek sum in comparison to major
currencies such as the US dollar and Euro, we can observe that the value of the Uzbek sum
depreciated significantly over the past years. As indicated in Figure 1, this decline in value
exceeded fourfold between the period of 2016 and 2023
[15]
.
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Figure 1. Exchange rate of the Uzbek sum against the US dollar and Euro, 2016-2023
If
the value of the Uzbek sum continues to decrease in the future, it will lead to an increase in the
cost of imported semiconductors, thus negatively impacting the profitability of the company.
Therefore, using currency options or forward contracts would enable the company to secure the
current exchange rates of the Uzbek sum and help it effectively manage and minimize the potential
risks arising from exchange rate fluctuations.
Exposure to credit risk
Credit risk is the possibility that a company may default on its financial commitments.
Investors become vulnerable to credit risk when they acquire a company’s debt. In the event that
a company fails to fulfill its debt obligations, credit default swaps (CDS) offer a protective measure
to investors.
CDSs are financial derivatives that enable investors to safeguard themselves from the
possibility of default on a specific debt instrument, such as a bond or loan. When a CDS is
employed, the purchaser pays the seller a premium in return for insurance against default on the
underlying debt. In case the borrower fails to repay, the seller of the CDS is obliged to reimburse
the buyer a sum matching the value of the underlying debt instrument.
If an investor decides to purchase a bond issued by LLC “Artel Electronics” with the face
value of 100 million sums
[16]
, but wants to minimize the potential credit risk associated with this
bond, they can decide to buy a CDS. By doing so, the investor can protect themselves against the
potential default of LLC “Artel Electronics” on their debt. In the unfortunate event that the
company fails to repay the debt, the investor will be entitled to receive financial compensation
amounting to the face value of the bond from the party that sold the CDS.
Risks of financial derivatives
In his annual letter addressed to Berkshire Hathaway shareholders in 2002, Warren Buffett
warned investors about the issues inherent in the over-the-counter derivatives market. He stated
that due to multiple flaws in the market’s functioning, derivatives could be regarded as “financial
weapons of mass destruction”. Buffett’s letter pointed out two particular vulnerabilities, namely
an excessive exposure to the risk of one party failing to fulfill its financial obligations (bilateral
credit risk) and insufficient collateral (margin) to offset potential losses
[17]
.
0
2 000
4 000
6 000
8 000
10 000
12 000
14 000
2016
2017
2018
2019
2020
2021
2022
2023
сен.23
USD
EURO
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These problems became more apparent during the global financial crisis of 2008. Prior to
the market collapse, American International Group, an insurance and finance corporation, held
CDSs for investments related to mortgages. As a result of the subsequent housing bubble burst and
the decline in mortgage values, the company incurred losses from its derivative positions and its
financial health was severely damaged. Eventually, the company’s substantial losses arising from
its derivatives agreements became overwhelming, prompting the intervention of the government.
Recognizing the potential devastating impact its insolvency could have on the financial system,
the Federal Reserve responded by allocating a significant sum of capital, amounting to 85 billion
US dollars.
Warren Buffett’s predictions regarding the derivatives market were proven to be accurate
as there was a significant economic disruption caused by extensive uncollateralized derivatives
positions. In response to these concerns and the flaws highlighted by American International
Group’s failure, the Dodd-Frank Act was introduced to tackle the issues in the derivatives market.
CONCLUSION
The derivatives market serves as a platform where investors gather to trade risks related to
financial markets. In today’s interconnected global economy, characterized by varying risk
profiles, derivatives play a crucial role in enabling businesses and investors to safeguard against
sudden and significant changes in prices and adverse events.
Before the crisis, the derivatives market lacked a robust regulatory framework that
effectively governed its operations. The absence of adequate regulations led to a surplus of bilateral
credit risk, meaning that the parties involved in derivatives transactions faced a high level of
potential default. Moreover, these transactions were not sufficiently collateralized, which means
that there was insufficient security or guarantees provided to offset any potential losses.
As the process of regulating the derivatives market progresses, it is crucial for
policymakers to focus on safeguarding this market as a means of risk management, rather than
allowing it to become a potential source of risk.
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www.britannica.com/topic/Code-of-Hammurabi
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How the Code of Hammurabi Influenced Modern Legal Systems.
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2181-3906
2023
International scientific journal
«MODERN SCIENCE АND RESEARCH»
VOLUME 2 / ISSUE 10 / UIF:8.2 / MODERNSCIENCE.UZ
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is
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