Till now we have discussed assets and liabilities and their classes. In this post, we are going to learn about derivatives that are available in these markets and exchanges for trading.
So what are derivatives?
A derivative is a financial contract that derives its value from an underlying asset or a group of assets. These contracts are between two or more parties and can be traded on an exchange or over the counter (OTC).
The underlying asset can be anything like stocks, bonds, currencies, commodities, interest rates, and market indices. A derivative’s value depends on changes in the price of these underlying assets.
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What are the different derivative types?
There are different types of derivatives based on the underlying asset and the opportunity it offers. Some of the most common types of derivatives used are as follows:
Futures
A futures contract is a financial derivative that obliges the buyer and seller to exchange an underlying asset at a pre-determined price on an agreed-upon expiry date. The important thing to note here is that the contract obliges the parties to perform the action mentioned in the contract. Here are the key points about futures contracts:
- The buyer of a futures contract is obligated to purchase the underlying asset at the predetermined price and receive the asset once the contract expires.
- The seller of a futures contract is obligated to sell the underlying asset at the agreed-upon price and deliver the asset to the buyer as per the contract terms.
- Future contracts are standardized for quality and quantity to facilitate trading on futures exchanges. They specify details such as the quantity of the underlying asset, purchase price (or sale price from the seller’s viewpoint), transaction date (payment and delivery timing), quality standards, logistics (eg. location, method of transport if applicable)
Futures can contain different types of underlying assets as mentioned below:
- Agriculture futures: These can include grain futures, fibers (like cotton), lumber, milk, coffee, sugar, and even livestock.
- Commodities: common commodities traded through futures contracts include wheat, corn crude oil, precious metals (gold, silver, copper), and more.
- Financial instruments: futures contracts exist for currencies, treasuries, and stock index futures.
To understand the future more clearly let’s take an example.
Suppose a farmer expects to produce 1000 Kg of rice in the next 12 months. To manage price risk, the farmer enters into a rice futures contract. Suppose the current price of rice is INR 25 per kg today. The farmer and the buyer will enter into a future contract to buy the rice in the future at an agreed-upon date. There can be three outcomes of this agreement.
- First is that the price of rise remains the same. So there is no loss or gain for anyone.
- Second the price of the rice increases and the buyer benefits by buying the rice at a lower price according to the contract.
- Third is the price of the rice decreases and the farmer benefits by selling it at a higher price according to the contract.
It is to be noted that the buyer will enter into the contract projecting an increase in the price of the rice in the duration specified in the contract and the farmer enters into the contract projecting a decrease in the price of the rice in the duration specified in the contract. Thus it can be said that future contracts are used to hedge risk. They also help in managing risk and providing liquidity in financial markets.
Options
Options contracts are another type of derivative. These are very similar to futures contract, but there are some differences between them because of which these are called options. The differences are as mentioned below.
- The futures contracts involve an obligation whereas options give the buyer the right, but not the obligation, to buy or sell the underlying asset at a specified price before the contract’s expiration.
- Futures are standardized agreements with specific details about the quantity and quality of the underlying asset. Traders must maintain a margin account and may face margin calls if the market moves against their position. futures contracts are settled daily, and the final settlement occurs on the contract’s expiration date. In contrast, in options, the buyer pays a premium for the right to exercise the option. options provide more flexibility as the buyer can choose not to exercise the option if it is not profitable. There are two types of options – call and put allowing for different strategies like buying calls, buying puts, writing calls, and writing puts.
So in essence, the difference lies in the obligation versus the right. With futures, both parties commit to fulfill the contract, whereas with options, the buyer has the choice to execute the contract providing a potential safety net against adverse price movements.
Let us understand this with an example. Suppose you hold a call option for a company ABCD stock with a strike price of $75, you have the right to buy 100 shares of company ABCD at $75 per share. If you hold a put option for company ABCD stock with strike price of $65, you have the right to sell 100 shares of company ABC at $65 per share.
Options contracts have an expiration date when they become invalid. The strike price determines the price at which the underlying asset can be bought or sold. Buyers pay a premium to acquire options contracts. the premium represents the cost of the option.
Suppose you expect a company ABCD’s stock price to rise to $90 within the next month. You find the call option contract for the company at a premium of $4.5 per share. The strike price for the call option is $75 per share. Each option contract covers 100 shares. you pay $450 for the options contract ($4.5 x 100 shares). As the stock price rises as expected and stabilizes at $100, you can exercise your call option to buy ABCD shares at the lower strike price of $75. It is used for speculation, hedging, or income generation.
Forwards
A forward contract is a customized agreement between two parties to buy or sell an asset at a specified price on a future date. Here are the key points about forward contracts:
- Unlike standardized futures contracts, forward contracts can be tailored to specific commodities, quantities, and delivery dates. These contracts can include grains, precious metals, natural gas, oil, and even poultry.
- Forward contract settlements can occur either on a cash basis or through physical delivery of the underlying asset. These contracts are not traded on centralized exchanges, they are considered over-the-counter (OTC) instruments.
Again let’s understand this with an example.
A coffee producer and distributor want to secure a price for the delivery of 10,000 pounds of coffee beans in six months. The current market price for coffee is $2 per pound. They enter into a forward contract to sell the coffee beans at a price of $2.1 per pound in six months. Settlement will occur either through physical delivery or cash settlement. In six months, the spot price of coffee has three possibilities:
- spot price remains the same, with no gains or losses for anyone.
- the spot price is above $2.1 coffee producer benefits
- spot price is below $2.1 coffee distributor benefits.
Forwards carry risk due to the lack of a centralized clearinghouse. They are commonly used by businesses to manage price volatility and secure future transactions.
Swaps
This is a special type of derivative. It involves exchanging cash flows based on interest rates, currencies, or other variables. A swap is a derivative contract through which two parties exchange the cash flows or liabilities from two different financial instruments.
Most swaps involve cash flows based on a notional principal amount, such as a loan or bond, although the instrument can be almost anything. Usually, the principal does not change hands. Each cash flow comprises one leg of the swap. One cash flow is generally fixed, while the other is variable and based on a benchmark interest rate, floating currency exchange rate, or index price. The most common kind of swap is an interest rate swap.
In an interest rate swap, the parties exchange cash flows based on a notional principal amount of an underlying security. the amount of the security itself is not exchanged; only the interest rates are.
For example, ABC company has just issued $1 million in five-year bonds with a variable annual interest rate defined as the London Interbank Offered Rate (LIBOR) plus 1.3% (or 130 basis points). Assume that LIBOR is at 2.5%, and ABC management is anxious about an interest rate rise. ABC finds another company, XYZ Inc., willing to pay ABC an annual rate of LIBOR +1.3% on a notional principal of $1 million for five years. in exchange, ABC pays XYZ a fixed annual rate of 5% on the same notional value for 5 years.
ABC benefits from the swap if rates rise significantly over the next five years. XYZ benefits if rates fall, stay flat, and rise only gradually.
if LIBOR rises by 0.75% per year, ABC’s total interest payments to its bondholders over the five-year period amount to $225,000.
If LIBOR rises by 0.25% per year, the calculations change accordingly.
Swaps are over-the-counter (OTC) contracts primarily between businesses or financial institutions, customized to their specific needs. They play a crucial role in managing risk and optimizing financial positions.
Risk and Leverage
Derivatives are usually leveraged instruments which means they amplify both potential rewards and risks. Traders use derivatives to access specific markets, speculate on price movement, or hedge existing positions.The Chicago Mercantile Exchange is one of the world’s largest derivatives exchanges.
Hedging vs Speculation
Hedging: Companies use derivatives to manage risk. For example, a farmer might hedge against price fluctuation in agricultural products as discussed in the futures contract example.
Speculation: Investors use derivatives to profit from price changes as explained in the futures contract example. They assume risk with the expectation of commensurate reward.
Risks associated with derivatives
Needless to say, derivatives come with their risks. Some of the risks are described below.
Market Risk: refers to the general risk inherent in any investment. It arises from changes in market conditions, including fluctuation in prices, interest rates, and economic factors. Investors must assess how much a derivative is affected by these changes. Understanding/reward ratio helps investors make informed decisions.
Counterparty risk: Arises if one of the parties involved in a derivative trade default on the contract. OTC markets, which are less regulated than exchanges carry higher counterparty risk. Counterparty risk can be managed by dealing with reputable and trustworthy counterparties.
Liquidity risk: applies to investors who plan to close out a derivative trade before maturity. investors need to consider if it’s difficult to close out the trade or if the bid-ask spreads represent a significant cost. Firms with good liquidity can quickly convert investments into cash to prevent losses.
Interconnection risk: interconnection risk relates to how the interconnection between various derivative instruments and dealers might affect a specific trade. Problems with one party, eg. a major bank acting as a dealer, could trigger a chain reaction affecting overall financial market stability.
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