Derivatives

Definition

Derivatives are highly speculative risk covering instruments. They are contracts to trade (buy or sell) underlying assets. Examples of such derivatives products are forwards, futures, options and swaps.

Forwards

A Forward Contract or simply a Forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract. The party agreeing to buy the underlying asset in the future assumes a long position and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time of trade is not the time where the securities themselves are exchanged.

Forwards

The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit or loss, by the purchasing party. Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive. A closely related contract is a futures contract but just that they differ in certain respects.

Characteristics of Forward Contracts

Customized Contracts (any quantity and forward date is possible). So, risk can be perfectly hedged by signing contracts for exact date and quantity required. Buyer and Seller know each other and so bear the risk of bear a risk of default on each other. Settlement is by actual delivery of contracted underlying asset and cash. Difficult to cancel as counterparty needs to agree as well. Lack liquidity as they are not traded on exchanges (with some exceptions like CBOT)

Futures

A Futures Contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today (the futures price or the strike price) with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange. The party agreeing to buy the underlying asset in the future, the "buyer" of the contract, is said to be "long" and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be "short". The terminology reflects the expectations of the parties - the buyer hopes or expects that the asset price is going to increase while the seller hopes or expects that it will decrease. The contract itself costs nothing to enter (besides margin) and so the buy/sell terminology is a linguistic convenience reflecting the position each party is taking (long or short).

Futures

The underlying asset to a futures contract can be currencies, securities or financial instruments and intangible assets or referenced items such as stock indexes and interest rates. While the futures contract specifies a trade taking place in the future, the purpose of the futures exchange institution is to act as intermediary and minimize the risk of default by either party. Thus, the exchange requires both parties to put up an initial amount of cash, the margin. Additionally, since the futures price will generally change daily, the difference in the prior agreed-upon price and the daily futures price is settled daily also. The exchange will draw money out of one party's margin account and put it into the other's so that each party has the appropriate daily loss or profit. If the margin account goes below a certain value, then a margin call is made and the account owner must replenish the margin account. This process is known as marking to market. Thus, on the delivery date, the amount exchanged is not the specified price on the contract but the spot value (since any gain or loss has already been previously settled by marking to market).

Characteristics of Future Contracts

Standardized Contracts for date of settlement and quantity. So, futures may not hedge risk perfectly as contracts for exact date and quantity may not always be readily available. Traded through organized exchanges. No default risk to buyer or seller as they do not know each other. Default Risk means buyers risk that seller may not honor the contract or vice versa. Exchange takes care of this risk. Unlike forwards, futures may or may not be settled by actual delivery. It may be just a cash exchange for loss/profit. In India, commodity futures are settled through actual delivery whereas stock futures are settled through cash payments. Futures market is more speculative as buying and selling of futures contracts is easy through the medium of an exchange. Investment for a futures trade is margin money deposited with the broker. This is a safety deposit to absorb losses. The only expense is the brokerage paid to the broker.

Payoff (Profit/Loss Position) in Forwards & Futures on Delivery Date

T delivery date K agreed delivery price as per contract Pt spot price at maturity Sellers (short position) Gain Pt < K His gain is (K-Pt). He would buy at a cheaper price in cash market and sell at a higher (contracted) price. Buyers (long position) Gain Pt > K His gain is (Pt-K). He would buy at a cheaper (contracted) price and sell at a higher cash market price.

Types of Futures

Agricultural Metallurgical Interest Bearing Assets Stock Futures Index Futures Forex Futures Miscellaneous catastrophe insurance, fertilizers like diammonium phosphate, orange juice, weather forecasts (weather futures on lines of index ), etc.

Options

An Option Contract is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to fulfill the transaction. The price of an option is derived from the difference between the reference price and the value of the underlying asset (commonly a stock, a bond, a currency) plus a premium based on the time remaining until the expiration of the option. An option which conveys the right to buy something is called a call while an option which conveys the right to sell is called a put. The reference price at which the option contract may be traded is called the strike price or exercise price. The process of activating an option and thereby trading the option contract at the agreed-upon price is referred to as exercising it. Most options have an expiration date. If the option is not exercised by the expiration date, it becomes void and worthless.

Options

In return for assuming the obligation, called writing the option, the originator of the option collects a payment, the premium from the buyer. The writer of an option must make good on delivering (or receiving) the underlying asset or its cash equivalent, if the option is exercised. An option can usually be sold by its original buyer to another party. Many options are created in standardized form and traded on an anonymous options exchange among the general public, while other over-the-counter options are customized adhoc to the desires of the buyer, usually by an investment bank. The 4 components to an Option Contract Types of Expiration, The Parties to an Option, ATM/ITM/OTM and Intrinsic Value/Time Value.

Types of Expiration

European Option an option that may only be exercised on expiration. American Option an option that may be exercised on any trading day on or before expiry. Bermudan Option an option that may be exercised only on specified dates on or before expiration. Barrier Option any option with the general characteristic that the underlying security's price must pass a certain level or "barrier" before it can be exercised. Exotic Option any of a broad category of options that may include complex financial structures. Vanilla Option any option that is not exotic.

The Parties to an Option

Writer the party who sells the option has the obligation to fulfill the terms of the contract should it be exercised Buyer the party who buys the option

ATM / ITM / OTM

At-The-Money (ATM) spot price at expiry is equal to strike price In-The-Money (ITM) spot price at expiry greater than strike price (call option) & spot price at expiry lesser than strike price (put option) Out-Of-The-Money (OTM) - spot price at expiry lesser than strike price (call option) & spot price at expiry greater than strike price (put option)

Intrinsic Value & Time Value

Intrinsic Value The price difference between the underlying security and the options strike price is the intrinsic value. An option must be ITM to have intrinsic value. Time Value Time Value is the amount by which the price of the option exceeds its intrinsic value. The time value premium of an option declines as the expiration date approaches. Intrinsic Value + Time Value = Option Price The 4 major factors which determine the price of an option price of underlying asset, strike price of option itself, time remaining until the option expires and volatility of the underlying asset

Characteristics of Option Contracts

Option Contracts are quoted-traded on options premium. Options are highly leveraged and more speculative. Option seller is called option writer. His gain is limited to option premium. His loss potential is unlimited. Option buyers loss is limited to option premium. His gain potential is unlimited. Option to buy is call option and to sell is put option.

Motives to trade in Derivatives

Hedging Speculative Arbitrage

Features of Derivatives Markets

Underlying Assets Delivery Speculative Settlement

Underlying Assets for Derivatives

Commodity Stock Currency Interest Rate Thus, basically, anything having uncertain financial value in the future can be traded in terms of derivatives.

Swaps

A Swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds, the benefits can be the periodic interest (or coupon) payments associated with the bonds. Specifically, the two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash flows are to be paid and the way they are calculated. Usually, at the time when the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable such as an interest rate, foreign exchange rate, equity price or commodity price.

Swaps

Commodity swaps are very rare as they do not have organized exchanges for the same. Currency swaps are very common. Many companies exchange USD for EUR at a future date. Any two currencies can be exchanged in this way. Interest rate swaps are also common. Fixed rate of interest is swapped with the floating one. Two floating rates in two different markets/currencies are also swapped. This is called as basis swap. The features of swap Negotiated Contracts, Intermediaries, Combination of Forward Contracts and Settlement.

Advantages of Derivatives

Risk Mitigation Rearrangement of Risk Ease in Trading Investment Money Flows Equilibrium

Disadvantages of Derivatives

Enhanced Risk Speculation Market Movements Hot Money Timed Settlement Accounting Ambiguities

Worldwide Derivatives Markets

Eurex Euronext LME CBOT CME NASDAQ TFX

Indian Derivatives Markets

BOOE NCDEX MCX ICEX BSE & NSE