How Issuers Create and Hedge Derivatives Linked to an Underlying Asset
Summary
The discussion explains that an issuer can create a contract whose payoff tracks an asset such as gold by promising clients a cash settlement tied to a defined reference price. This is primarily a contractual arrangement. An exchange traded fund, product, or note is offered as a more conventional route, though it may involve holdings or trades in the underlying asset.
The key operational issues are defining a credible, manipulation-resistant benchmark and managing the issuer’s exposure. A simple one-for-one payoff may be hedged with the underlying, futures, or options markets. More complex payoff designs make hedging more central and depend on available instruments for transferring risk. The answers illustrate the distinction between specifying a payoff and replicating or hedging it; they do not present a detailed valuation framework. The discussion also makes broader claims about equity returns and option pricing, but supplies no supporting data, so those claims should not be treated as evidence established by this document.
Key ideas
- A linked derivative can be created through a contract specifying cash flows tied to an asset reference price.
- The reference price should be clear and resistant to manipulation.
- An issuer needs a hedge if it wants to limit the market risk created by the contract.
- Underlying assets, futures, and options may serve as hedging instruments.
- More complex payoffs require suitable markets and a more involved hedge.
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Full text
# How does one actually create a derivative of a given underlying security? # How does one actually create a derivative of a given underlying security? Let's say I'm an investment bank and I want to create a derivative whose value tracks that of gold. I don't want this derivative to in any way trade in the underlying security, so no futures or options contract. I just want an abstract investment I can sell (as a bank) whose price has (ideally) 100% correlation with the price of gold. How is this done? ## Answer by Bob Jansen (score 3) https://quant.stackexchange.com/a/61932 As noob2 says in the comments: it would be easier to create an Exchange Traded Fund/Product/Note which would involve trading in the underlying. If you still want to do this: The bank enters a contract with their customers that says: on such and such dates you can sell this contract back to us for the price of gold. It's a matter of contract law more than of finance. From a finance perspective there are two issues which are important and do need to be solved: - What is the price of gold at a given moment. Ideally, this price is recognizable as 'the price of gold' and hard to manipulate. In the past, prices of derivatives have been manipulated. For instance by banging the close. - The bank needs to hedge the contract if it doesn't want to expose itself to price risk. ## Answer by demully (score 3) https://quant.stackexchange.com/a/61941 I don't know how to say this in any way that does not sound unkind, the avoidance of which is 100% my intention... [and I saw they pulled your other question, slightly unfairly in my more tolerant opinion, so I'll postscript answer that as well ;-) ]. Your gold example is a bad one... precisely because the issuing bank can, and will, hedge its gold exposures via any/all of the bullion, gold futures or options markets. I can easily issue "gold notes" to my clients that pay 100% of what gold did; and those notes will never need hedge themselves. Or just launch a Gold ETF, which is a derivative (albeit an unlevered one) of the gold price. And I could this for eg Rhodium, Carbon Prices, or perpetual preferred equity if the mutual urge to consummate was there between us. There's nothing special about gold here. The problems start to arise when the bank wants to start to create products that are not simply 100% related to the underlying. Then the need to hedge becomes essential. This hedging requires the existence of a futures/options market in that underlying. best, DEM [Black-Scholes versus reality. You won't like this answer; but it's an answer nevertheless, maybe not of the EXACT question you intended. Look at XVV... you're long of VIX. VIX being settled against VIX futures. Which are hedged against a wide range S&P options. Which embed expectations of implied vol, that the hedging thereof by all banks etc. cause realised losses when realised vols are (usually) lower than implied. Put simply, the vast majority of equity returns has come from the put-selling versus the call-buying component of investors' buying equities There's a "compensation for insurance" within the "equity risk premium", when one compares to derivatives prices that, by definition of construction, have to assume zero returns on the forward (aka the risk-neutral measure, to prevent arbitrage.)]
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