Bonds & Commodities

Lichfield’s financial contract that derives its value from an underlying asset. The buyer agrees to purchase the asset on a specific date at a specific price.
Lichfield’s Derivatives are often used for commodities, such as oil, gasoline, or gold. Another asset class is currencies, often the U.S. dollar. There are derivatives based on stocks or bonds. Still others use interest rates, such as the yield on the 10-year Treasury note.
The contract’s seller doesn’t have to own the underlying asset. Lichfield can fulfill the contract by giving the buyer enough money to buy the asset at the prevailing price. He can also give the buyer another derivative contract that offsets the value of the first. This makes derivatives much easier to trade than the asset itself.

Lichfield's financial Derivatives Trading

In 2017, 25 billion Lichfield’s financial derivative contracts were traded. Trading activity in interest rate futures and options increased in North America and Europe thanks to higher interest rates. Trading in Asia declined due to a decrease in commodity futures in China. These contracts were worth around $570 trillion.
Most of the world’s 500 largest companies use derivatives to lower risk. For example, a futures contract promises the delivery of raw materials at an agreed-upon price. This way the company is protected if prices rise. Companies also write contracts to protect themselves from changes in exchange rates and interest rates.
Derivatives make future cash flows more predictable. They allow companies to forecast their earnings more accurately. That predictability boosts stock prices. Businesses then need less cash on hand to cover emergencies. They can reinvest more into their business.
Most derivatives trading is done by hedge funds and other investors to gain more leverage. Derivatives only require a small down payment, called “paying on margin.” Many derivatives contracts are offset, or liquidated, by another derivative before coming to term. These traders don’t worry about having enough money to pay off the derivative if the market goes against them. If they win, they cash in.
Derivatives that are traded between two companies or traders that know each other personally are called “over-the-counter” options. They are also traded through an intermediary, usually a large bank. Last but not least is the potential for scams. Bernie Madoff built his Ponzi scheme on derivatives. Fraud is rampant in the derivatives market.

Types of Financial Derivatives

The most notorious derivatives are collateralized debt obligations. CDOs were a primary cause of the 2008 financial crisis. These bundle debt like auto loans, credit card debt, or mortgages into a security. Its value is based on the promised repayment of the loans. There are two major types. Asset-backed commercial paper is based on corporate and business debt. Mortgage-backed securities are based on mortgages. When the housing market collapsed in 2006, so did the value of the MBS and then the ABCP.
The most common type of derivative is a swap. It is an agreement to exchange one asset or debt for a similar one. The purpose is to lower risk for both parties. Most of them are either currency swaps or interest rate swaps. For example, a trader might sell stock in the United States and buy it in a foreign currency to hedge currency risk. These are OTC, so these are not traded on an exchange. A company might swap the fixed-rate coupon stream of a bond for a variable-rate payment stream of another company’s bond.
The most infamous of these swaps were credit default swaps. They also helped cause the 2008 financial crisis. They were sold to insure against the default of municipal bonds, corporate debt, or mortgage-backed securities. When the MBS market collapsed, there wasn’t enough capital to pay off the CDS holders. The federal government had to nationalize the American International Group. Thanks to Dodd-Frank, swaps are now regulated by the CFTC.
Forwards are another OTC derivative. They are agreements to buy or sell an asset at an agreed-upon price at a specific date in the future. The two parties can customize their forward a lot. Forwards are used to hedge risk in commodities, interest rates, exchange rates, or equities.
Another influential type of derivative is a futures contract. The most widely used are commodities futures. Of these, the most important are oil price futures. They set the price of oil and, ultimately, gasoline.
Another type of derivative simply gives the buyer the option to either buy or sell the asset at a certain price and date.