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Derivates & REITs

The derivatives are financial activities that ‘derive’ their existence from other financial activities. In particular, their value derives from the market price of an underlying instrument. The two most known among the group are undoubtedly the futures and the options contracts. Among the different factors that compete to their success, there surely are the elevated liquidity, the lower costs of transaction and the fact that they allow to get a complete coverage from the financial risk and at the same time to speculate for elevated values through investing a limited amount of money.

The possibility to speculate, with a modest patrimony for elevated amounts is an advantage that attracts above all the small investors with a high propensity to the risk. The mechanism concerning the negotiation of the futures and the options allows in fact to use less to risk a very elevated value. Such activity is known as ‘leverage’, because it corresponds to using a lever to increase the effectiveness of the result. Obviously, the leverage is used in the hope that the prices move toward the favorable direction for the trader. If they move in the opposite direction, the leverage increases the amount of the losses. 

An example can be useful. Let’s imagine that a trader is able to spend 1.000 Euros to acquire a financial activity valued 10.000. An increase of the price of the activity equal to 10% implies for the investor a profit of 1.000 that is equal to the double of the invested capital. A doubling of the capital constitutes a 100% outcome. If, instead, the return is -10%, the loss is 1.000 euros that is equal to the whole invested capital or a 100% loss. The leverage implicates therefore a strong increase of the volatility of the investment return. These properties make the derivatives attractive and the enormous demand favors in turn the liquidity of the market (the possibility to effect a transaction to the market price without negatively influencing it). In a little liquid market, in fact, a trader that intends to sell a consistent part of the activity takes the risk to execute the sale for an lower price to that observed in the moment in which he had decided to sell because of the scarce number of potential buyers (as well as a potential buyer can perform the purchase for a higher price). The elevated liquidity in many futures markets minimizes the impact of such effects considering that a presence of potential buyers has, as opposite, many potential sellers in every moment. Vast liquidity has then also the effect to reduce the costs of transaction.

Derivatives                                                                                                                                                                                                            REITs

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(source of the article is the book "Shares", Marco Liera, Il Sole 24 Ore)

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