Handbook of Investment Administration

Chapter 15

DERIVATIVE PRODUCTS

15.1 INTRODUCTION

A derivative is a financial instrument that is based on another asset, such as commodities, shares in an individual company, an index or any other financial asset.

Derivatives are constructed and used to solve a wide range of specific needs. In their original form, they were developed so that a farmer growing crops could secure the price he was to obtain in advance rather than being open to the vagaries of what the price might be when he could harvest his crop and get it to market.

Derivatives have had a controversial history because of their ability to generate huge losses and have been at the core of some major business failures such as the collapse of Barings Bank, the bankruptcy of Orange County in the United States and more recently, the failure of the hedge fund, Long Term Capital Management.

They are often portrayed in the news as being the cause of a problem that has arisen. Invariably, however, it is not the derivative itself that is a problem but its inappropriate use, lack of control or lack of knowledge that allows problems to arise. What it does highlight is the risk attached to the use of these instruments.

Derivatives have traditionally not been included in the portfolios of private clients. This is now changing and there is a range of derivative products appearing that are opening this asset class up to the retail investor. This can be seen in the range of derivative products that are now listed on the London Stock ...