Financial Innovation and Risk Sharing
The financial collapse of 2008 brought a lot of attention to the "financial innovations" of the past 10 years, particularly to terms we hear in the news media but often fail to understand. Derivatives, credit swaps, hedging, futures contracts, etc., were all oft-touted financial innovations before the 2008 to 2009 recession, and remain for the average person shrouded in mystery even now, after they have long fell from their pedestal. However, these instruments are still important and still used today.
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Hedging and Risk Sharing
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One of the main goals of the new financial innovations of the past two decades has been risk management. The so-called hedge funds, which also received press for their role in the economic downturn, are named for one of the new innovations of risk management, the hedge. In a hedge, a position is established in one market to offset risk of price changes in some opposite position, using a variety of financial instruments. One common hedging instrument is the futures contract, a type of derivative. Other hedging instruments include insurance, swaps like credit swaps or debt swaps, options and various other derivatives.
Futures Contracts and Risk Reduction
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To illustrate a hedge, lets take the example of a futures contract. In a futures contract, a party agrees to buy or sell an asset to another party, at an agreed-upon date and at an agreed-upon price. This reduces the risk of price changes on profits. For example, imagine that a farmer plants wheat at the beginning of the season, but doesn't know what the price of wheat will be when he actually harvests his crop. If the price of wheat goes up, it could be a happy windfall for the farmer, but if the price of wheat plummets, the farmer may be in serious trouble. To protect against the risk of a reduction in the price of wheat, the farmer might make a futures contract for his crop, agreeing to sell his wheat at a set price to a specific party on a set date. Once the futures contract is in place, the risk of price movements is effectively moved to the owner of the futures contract, as the farmer no longer cares what the price of wheat is and gets the same price for his wheat no matter what.
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Other Derivatives: the Option
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An option is another type of derivative that arose in the financial innovations of the recent market, designed to reduce risk by spreading risk to multiple parties. The option is an agreement which gives one party the right, but not the obligation, to sell or buy an asset to or from the other party, on a certain day and at a certain price. In our wheat farmer example, the farmer could alternatively obtain an option on his wheat, allowing him to sell his wheat at a agreed-upon price should he choose to at the end of the harvest. From the farmer's perspective, this is even a better risk-reduction instrument, as if wheat prices go down, he's locked in a safe price already, and better, if wheat prices go up, he can let the option expire and sell his wheat in the market for a better price. In this case, the farmer wants the price of wheat to rise but doesn't care if it falls, and has therefore reduced his risk to price changes.
Other Types of Derivatives
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There are many other types of derivatives besides the futures contract and the option, such as swaps, credit derivatives, equity derivatives and more. Derivatives are so-named because they are not a stand-alone asset and "derive" their value from another instrument, called the underlying asset. In the case of our farmer and his future contract (or option), the future contract and the option are derivatives, and the underlying asset is the farmer's wheat. Derivatives were one of the most widely discussed financial innovations after 2008 because derivatives ended up being traded in a market of their own, sometimes with ill-defined rules and with various problems in calculating their estimated value. In other words, if the farmer makes his futures contract with a firm, its very possible that this firm will actually sell or swap this futures contract for other derivatives or other assets entirely. This hints at why risk reduction strategies sometimes fail - the market for derivatives turned out to be quite risky in itself, despite the farmer's reduced risk for himself.
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