Defaqto

Background

Mention derivatives and most people will think of Jérome Kerviel, the infamous Société Générale derivatives trader, who managed to lose his bank £3.9m by betting on European stock markets rising, when, in fact, they fell.

But, used correctly derivatives are a way for insurance companies, pension funds, farmers, City traders and private investors, as a way of hedging their bets.

'Hedging' can be useful because it can protect companies and banks against unexpected developments, such as sudden rises or falls in the value of shares, currencies or commodities.

Initially it was commodities like wheat, hogs’ bellies or coffee which were used for such trading. Nowadays you can trade in a whole range of commodities, such as oil, gas and precious metals.

Traders bought and sold 'future' contracts - an agreement to buy wheat, say, in three months’ time at a certain price – thereby protecting themselves from the worry that a crop failure might drive up the price of wheat in the intervening months.

In the 1980s, financial futures began to dominate trading, which involved buying and selling futures or options on shares, bonds or currencies.

Some investment bankers began to turn hedging into a profitable business in its own right, gradually developing complex ways of hedging.

Options

Options and swaps became the next most common form of derivative trading after futures.

Options were invented because people liked the security of knowing they could buy or sell at a certain price in the future, but wanted the chance to profit if the market price suited them better at the time of delivery.

Swaps are, as their name suggests, an exchange of one thing for another. They are generally used to swap one income stream for another using interest rates or currencies. For example, a company might want to swap a floating interest rate for a fixed interest rate to minimise financial uncertainty.

There are derivatives available on almost all types of asset which are traded - the main four being shares, bonds, currencies, property and commodities.

New ones are even being developed for catastrophes, such as earthquakes, and even on the creditworthiness of investors.

How they work

Derivatives are used widely by City traders because, as a simple monetary value, they are much more flexible to deal with than the underlying products. The value is based on the price of the underlying product, but most contracts are settled in cash terms.

This enables banks, traders or investors such as George Soros to bet on price movements without having to deal in the actual assets. So you could gamble, for example, on the output of Iraqi oilfields, without having to buy one.

Derivatives can also be 'leveraged' or geared up, to be worth many times the value of the underlying investment- so that if the price of the asset moves up by £1, the value of the derivative could change by £10, too.

These instruments can also be used to insure against adverse price moves. Put simply, you can buy a derivative which bets that the market will move against you so that you win either way.

High risk

As the experience of Jerome Kerviel demonstrated, derivatives trading can be high risk because contracts, which may be worth millions if the market moves in a certain way, cost only a fraction of that value.

Usually the market will not move that much and the contract will be settled or sold to somebody else for a small gain or loss. However if it does shift significantly, losses can be huge.

On exchanges, traders normally have to pay any losses incurred on their position at the end of each day in order to prevent risks getting out of hand. But in the case of Jerome Kerviel, he allegedly concealed his trades and the size of his positions was not realised until it was too late.

Banks have complex computer programmes to flag up how much they could lose if the market moved by a certain amount and regulations require them to put money aside to protect against possible losses.

Covered warrants

Since October 2002, private investors have been able to buy covered warrants through the London Stock Exchange.  As a result, private investors are able to play on a level playing field with fund managers and traders.

Put simply, in return for a premium, covered warrants allow you the option of buying or selling a share at a fixed price at a specified future date. If, at this date, the shares are more expensive than the agreed price, you make a profit. This can be useful protection against falling share prices.

If you are worried that a share might fall in value, you would be able to sell the stock at a set price. The drawback is the cost of the covered warrant.

Alternatively, if you think a share is set to soar, you could, with a warrant, purchase the right to buy the share at a certain price.

For a relatively small outlay, you could reap the same gains as another investor who has bought a large  holding of the same share.

Generally speaking, warrants are far more volatile than shares, exaggerating the price movements of the underlying stock, both up and down, so these are high risk instruments which should be used with care.

How much can I lose?

Unfortunately, you could lose your entire investment. If you call the future share price wrongly, the value of the covered warrant can fall to nothing.

For example, if a covered warrant allows you to buy a share at £1, but the price of the share then drops to 50p, then no one will pay for the right to buy a share at double the market value.

Do covered warrants have any other uses?

The London Stock Exchange argues that covered warrants can act as an insurance against falling share prices.

For example, if you were buying 10,000 £1 shares, you could buy a covered warrant that allows a further 10,000 shares to be bought at 80p in a year’s time.

If 11 months later the share price has fallen to 90p, you would have lost £1,000 on the original investment.

However the covered warrant, so close to maturity, is likely to have risen in value so that potentially it covers the loss on the original investment.

Fund managers have, for a long time, used covered warrants to hedge their share purchases. Despite this, over the last 10 years, when charges are factored in, the average fund manager has underperformed the FTSE All Share index.

Is it wise for private investors to trade in covered warrants?

In September 2002, the Financial Services Authority (FSA) relaxed its rules barring the marketing of covered warrants to the general public.

Six City institutions announced that they would start offering covered warrants to investors and since  October 2002, warrants have been traded on the LSE in the same way as ordinary company shares.

Initially, the LSE said that sophisticated investors were being targeted. But today, warrants are being used by the wider investing public.

But given the high risk and complex nature of covered warrants, financial advisers recommend that only sophisticated investors with portfolios in excess of £500,000 should consider using them