Demystifying Derivatives Law: Essential Concepts for Market Participants
Despite their often-misunderstood reputation as speculative tools, derivatives play an essential role in finance. This makes it crucial for market participants to understand how they function and their many purposes.
From hedging risks to speculating on price movements, they’re used to manage investment portfolios and enhance returns. They also help in market pricing and enhance liquidity.
Limits are important concepts in calculus and mathematics, as they are used to define other topics, such as derivatives law and regulations. In simple terms, limits are the values a sequence or function approaches as its input (or index) approaches some other value.
The pointwise limit of a sequence f(n) g(n) is the point at which the ratio of the numerator and denominator approaches zero. This is a very important property, ensuring the sequence is finite. Alternatively, it is also possible for a sequence to be divergent and not converge pointwise to a certain value, which is called unbounded.
The uniform limit is a more accurate definition since it guarantees that the sequence will not approach zero. However, it does not guarantee that the sequence will be finite, so it is still not an idealization. To be a good limit, the uniform limit must satisfy several conditions. These include:
Margin is important in business commerce, financial accounting, and investing. It is the difference between a company’s revenue and its costs and is often expressed as gross profit margin, operating profit margin, and net profit margin.
Some investors choose to buy on margin, depositing a percentage of the total purchase price of their securities in their brokerage accounts. This gives them “leverage” to increase their buying power and allows them to make larger trades than possible with only the funds in their accounts.
However, this comes with significant risks. If the value of an investor’s marginal securities declines, a broker may issue what is known as a “margin call.” In this scenario, the investor must deposit more cash into their account or sell their marginal securities to cover their losses, which can be difficult and time-consuming.
Additionally, the interest rate a brokerage firm charges on margin balances varies from one to another, and the rate may also change day-to-day as the value of the marginal securities in a trading account rises and falls.
The current global financial crisis has taken many forms, but one common theme is the failure of conventional risk management. The root of this problem was a misunderstanding of the nature of market risks and the ability of financial institutions to manage those risks.
Market risk is the sensitivity of derivatives to changes in the prices of the securities, commodities, currencies, and interest rates they reference. This type of risk is best controlled through a value-at-risk limit system, which provides senior management with an easily understood way to monitor and control the amount of capital and earnings at risk in derivative positions.
Ideally, the system of value-at-risk limits should be integrated into an institution’s overall risk management framework. However, the specifics of how this is done should consider the nature, size, and complexity of the institution’s derivative activities. In addition, the inter-relationship between different types of risks should be considered in establishing management responsibilities and determining risk measurement methodologies. It should also include a system for monitoring and controlling the overall exposure to risk in derivatives, as well as stress testing of positions and frequent management reporting.
Hedging is using derivatives to protect an existing position or portfolio against risk. If a hedge is executed successfully, it should generate profits when the primary position or portfolio produces losses.
Large corporate entities typically use hedges to hedge their exposures to input costs. For example, airlines may hedge jet fuel prices so they are not exposed to day-to-day price fluctuations. Food companies may hedge the prices of key ingredients like corn or sugar to avoid expensive changes in market conditions.
Hedging is a complex accounting area requiring extensive knowledge of financial markets, access to certain instruments, and a delicate balance of timing and execution. While hedging has a role in the marketplace, speculative trading should be discouraged, and directors should understand when they are being asked to speculate instead of hedging. When speculation results in a different outcome than hedging, it impairs the functioning of the market, and directors should be careful not to engage in this activity. ICE’s robust market structure has significant safeguards to prevent speculation and market manipulation.
Arbitrage is the simultaneous purchase and sale of assets in different markets to exploit price differences. This can be done with any financial instrument, but the simplest example is buying an asset in one market and selling it in another. For this to work, the prices must be close to the same.
Arbitragers play a role in keeping markets efficient. They buy expensive assets in one market and sell cheap ones in another to align prices. This is why financial markets have low slippage.
Many attorneys in the securities, banking, and finance industries encounter derivatives law issues regularly. They may advise clients on trading and risk management strategies, negotiate and review derivatives agreements, handle Commodity Futures Trading Commission (CFTC) enforcement matters, or litigate related disputes. They should have a basic understanding of the laws and practices that govern derivatives, including those related to insolvency, netting, and set-off.