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The history and genesis of derivatives can be traced to commodity derivatives used by farmers and millers for the purpose of insurance. Moving past the barnyard basics, a derivative is a contract between two or more than two parties where the value is associated with and formed on basis of underlying financial asset, security or index. Looking further into the financial futures crystal ball, derivatives are used primarily for speculating as well as hedging.
The ABC of Derivatives
A futures contract is a derivative as its value is influenced by the way in which the underlying contract performs. In the same way, stock options are derivatives as their value is derived from the underlying stock. The very basis of profits is from changing prices within the underlying asset, security or index.
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The Guessing Game: Derivatives and the Fine Art of Speculation
Traders can profit from anticipated fall in the index price through sale pertaining to future’s contract. This is called going short.
Beating the Odds: Derivatives and hedging
Derivatives are used as a hedge to use risks linked with the price of the underlying asset to be transferred between parties associated in a contract. Though risk is reduced by hedging, it still remains given that prices will change. For example, in the agricultural sector, for a particular type of commodity locked in specific price, there could be rising rates due to reduced supply and this can lower the amount of income accrued from this. Similar, prices would drop and more money would have to be paid if supply side suddenly experiences a massive increase.
Derivatives allow investment permitting persons to buy or sell option on a security. These are types of investments where the underlying asset is not owned by the investor. but a bet is made in the direction of price movement of underlying asset through an agreement with another party.
Many different kinds of derivative instruments abound such as options, swaps, futures and forwards contracts.
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Derivatives: A Financial Language Few Understand
Derivatives are difficult to comprehend on account of the fact that they communicate in a language very few can comprehend. Each derivative has an underlying asset on which its price, risk and basic term structure is based. The perception of risk of underlying asset includes the risk perception of the derivative.
Pricing of derivative may feature a strike price, This is the price at which it can be exercised. In reference to fixed income derivatives, there is also a call price at which issuer can convert a security. Investors can take different positions- long or short. Long position means you are purchasing the derivative and short position denotes you are the seller.
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Derivatives have 3 primary uses in the market: hedging a position, increasing leverage or speculating movement of an asset. Hedging positions is usually carried out to offer protection against risk of an asset. If one owns shares of a stock and wants a safeguard against possibility that stock prices will fall, the put option has to be purchased. In such a scenario, if stock prices rise, there is a gain as one owns shares and if they fall, you gain because of the put option. Potential security associated loss is hedged using an options position.
Leverage: The Art of Capitalizing on Derivatives
Leverage can be really enhanced through the use of derivatives. These options are most valuable when the market is at its volatile best. The movement of the option is magnified if the price of an underlying asset moves strongly in a favorable direction.
High volatility= High value of put and calls
Speculation: A Technique That Involves Betting
Through this technique, investors bet on the future price of the asset. As options offer investors the chance to leverage their position, large speculative plays can be carried out at modest cost.
Trading: OTC versus on an exchange
Derivatives can be purchased or sold in dual ways- either trading over the counter/OTC or on an exchange. OTC derivatives are contracts that are made between parties on a private basis for example, swap agreements. This is a market which is the larger of the two and relatively unregulated. Derivatives trading on the exchange, in contrast, are standardized contracts. Largest difference between two markets is in the case of OTC contracts where there may risks associated with counterpart as contracts are created privately and therefore not subject to regulation. This risk is missing from exchange derivatives where the clearing house acts as the go-between.
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Derivatives: Basic Types
There are three basic types of contracts namely options, swaps and forward/futures contract. There are variations in each case. Just like a television has different channels, tuning into any of these contracts will yield differential results. While options are contracts that permit but do not carry the obligation to purchase or sell an asset, thereby being used by those investors who do not want to risk position in asset outright and want exposure in case of large price movements in the underlying asset.
Options Trading: The Choices
Short Call: If the stock price is going to decrease , the call will either be subject to selling or writing. If the call is sold, the buyer of the call(long call) controls whether the option will be taken or not. In case you are in the short, you give up control as a seller. For the writer of the call, payoff is equivalent to premier received by buyer of the call id there is a decline in the stock price. If the stock rises more than the exercise price and the premium, money will be lost by the writer.
Short Put: If it is believed the stock price will rise, one has to sell or write a put. For writers of the put, payoff is equivalent to premium received by the stock’s buyer in case stock price rises. When stock price lowers beneath the exercise price without the premium, money is lost.
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Long Call: In case a stock price will increase, the right (long) to buy (call) it is referred to as long call. When the long call is held, there is a positive payoff if stock price is greater that exercise price by more than premium paid for each call.
Long Put: If the stock price decreases, the right to sell or put the stock is bought(long). Long put holders get a positive payoff in case the stock price is lower than the exercise price by the premium paid for the put.
Asian/average option: This is an option associated with the average value of an underlying asset for specific dates within the life of the option.
Basket option- An option with a payoff associated with a portfolio or basket of assets.
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Credit Derivative
This is an OTC derivative aiming to transfer credit risk from one party to another Through synthetically creating or elimination of credit exposures, institutions are able to manage credit risks more easily. Credit derivatives come in many avatars- 3 key ones are total return, credit linked swap and credit default. Whether the derivatives are plain vanilla or more complicated and exotic, distinction is mainly on account of how differentiated or complex the derivative us.
Derivatives: Moving Beyond Cash Instruments
Derivatives are differentiated from cash instruments in that they are contracts between two/more parties to convey ownership of asset rather than the very asset itself. Derivatives show an agreement between parties which is hugely flexible and has a starting and ending date. Investors can try derivatives for capturing the profit emanating from price variations within the investment. This is why derivatives are referred as as leveraged investments. If the leverage is employed, both positive and negative results matter in an even bigger way.
Investors are using price variations in underlying investment to capture profits through derivatives. Another reason why derivatives are a better investment is because you can control more asset for less cash wherein the fraction of the price of the underlying asset is used to derive profits.
Derivatives are also extremely flexible because anything can be used as an underlying asset, even the weather or the rate of crop growth.
Most common derivatives are options while warrants and swap contracts are some other. Derivatives are contracts that are formed between buyers and sellers.
Also known as wasting assets because they have limited shelf life, with a set expiry date, their value decreases as expiry nears. Payoff is based on the expiration date, though this is not so in all cases. Money is not always exchanged at the start of the contract though cash or spot price is price an investor has to pay up for immediate purchase.
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Much like the underlying cash instruments, certain derivatives are traded on established stock exchanges such as NYSE or Chicago Board of Trade. Exchange traded derivatives provide clearing and regulatory safeguards for investors. Certain other derivative instruments such as forwards, swaps and exotic derivatives are traded outside formal exchanges. Many large organizations work as derivatives dealers, customizing derivatives to be tailor made to suit the needs of the client.
Swaps: A Special Kind of Derivative
Swaps are those derivatives where counterparts exchange cash flow and/or other variables linked with different investments. A swap often occurs as one party has comparative advantage in a certain area while another can borrow more freely at fixed interest rates as opposed to variable.
The Many Different Flavors of a Swap:
Plain vanilla swap is the simplest variation of this type of derivative.
Interest rate swaps are when there is exchange of fixed rate for floating rate loan by parties. Consider that if one party has a fixed loan rate and floating liabilities, it may enter into a swap with a party that has floating rates to match the rate to the liability. Interest rate swaps are also possible through option strategies or swaption which gives the owner the right yet not the obligation to enter into a swap.
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Currency swaps are when a single party exchanges loan payments + principal in one currency for payments and principal in another.
Commodity swaps are a type of contract where payment is based on the price of the commodity which is underlying. Akin to a futures contract, the price at which the commodity will be sold can be ensured and price to be paid can be fixed by the customer.
Moving ahead, another type of contracts are forward/future contracts which are formed between parties for purchasing or selling assets in the long term for a specified price. Such contracts are composed in reference to spot or the day’s price. The profit/loss incurred by the parties is equal to the difference between spot price at delivery time and forward/future price. Such contracts are used for hedging as well as speculating with respect to future crisis.
Forwards and Futures: A Big Difference
Forwards and futures contracts differ in that futures refer to standardized contracts that are traded on exchange while non standardized, OTC contracts are forwards.
Derivatives- Deriving Value from Asset
Financial instruments such as stocks, currencies, bonds and commodities are primary or cash based. Value of cash instruments is directly determined by the market. In contrast, derivative gets its value from another asset or variable which is financial in nature. For instance, a stock option derives its value from the stock, while interest rate swap derives its value from an interest rate index. Asset from which the derivative is gaining traction is known as the underlying asset.
Benefits: The Derivative Advantage
In the current international markets, derivatives has gone from strength to strength. Derivatives can derive profits from transitions in interest rates and equity markets across the world, currency exchange rate shifts and global demand-supply chain for commodities. So, derivatives offer investors the flexibility to trade across numerous commodities such as agricultural products, precious and industrial metals and products like oil.
Derivative instruments add to the traditional investment portfolio and allow diversification, helping to hedge against inflation and inflation and returning profits far beyond the traditional investments can.
Price discovery and risk management are the two main benefits of trading in derivatives. Futures markets are based on information flow across the world which then shapes current or future prices of underlying assets on which derivatives are based. Price discovery or constant changes in the price of the commodity as a result of changes in information is a feature of derivatives trading. Within some futures markets, there can be geographical dispersal of underlying assets and the price of the contract with the shortest time to expiration serves as a proxy for underlying assets. Price of all future contracts are the price that can be accepted in the face of risk of future price uncertainty. Options also aid in price discovery and the way volatility of markets can be viewed.
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Different forms of hedging actually protect investors against losses. The most important purpose of the derivatives market is risk management which involves identification of a desired risk level, identification of actual risk and alteration of this in certain directions, thereby leading to hedging and speculation. This leads to better risk management.
Derivatives also improve market efficiency for underlying assets. If there is a discrepancy between prices, investors will definitely sell the more expensive asset and purchase the cheaper one till prices stabilize. In this context, derivatives create market efficiency.
Another great advantage is that derivatives also lower market transactions costs. Derivatives are like insurance policies for positions, but the premiums (cost of investment) has to be reasonable for it to be an attractive proposition. The can be used to protect against significant exposure of business in terms of movement in asset price, interest or exchange rate or default of a creditor.
Derivatives contribute to flow of capital or raising credit availability. in the economy. They also enable businesses to manage effective exposure to external influences on business over which there is no control.
Risks: The Darker Side of Derivatives
Lack of transparency is a key risk in the derivatives market, especially in the OTC scenario. Market participants and regulators can be blindsided by the OTC market. Lack of awareness of overall market positions can also reduce market liquidity. In addition to lack of transparency, there is also the matter of counter-party risk or the risk that is derived till contracts satisfy their obligations. For example, if there is failure to supply goods or services in a futures contract, there can be a downside for the counter-party. Both systemic and operational risks impact derivatives contracts. Operational risks result from lack of control systems or human errors while systemic risk describes risk to the financial system on account of default of a major player in the derivatives market. Default in corner A of the world can have massive implications for the entire globe, another risky offshoot of the derivatives market. Credit default swaps are opaque and complex making it difficult for people to understand risk in the complete sense of the term.
Conclusion
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What goes up must come down but the same is not always true for the derivatives market. The exciting world of futures trading involves high stakes thanks to the derivatives market. Playing for higher stakes means greater profits in the world of derivatives. Dealing in derivatives is an art and a science. The business of derivatives makes the economy vibrant too. Not without its risks, derivatives market is as multifaceted and far reaching in its influence as the high stakes it involves.
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