Derivatives are important financial instruments used by investors to transfer risk attached to an asset to other willing investors. They are designed as financial contracts between two parties where each party does something for the other either in the present or in the future.
By definition, a derivative is a financial instrument whose value is dependent on the value of the underlying asset or asset group of assets. The underlying asset can be commodities, stocks, interest rates, market indices, bonds, and currencies.
Derivatives can be traded privately (over the counter), as well as on an exchange like the Chicago Mercantile Exchange, CME. There are many types of derivative contracts available in the financial market, and they may appear confusing at times. However, there are basic ones from which all the complex ones are designed.
There are 4 types of derivatives:
- Forwards – Private agreements where the buyer commits to buy, and the seller commits to sell.
- Futures – Standardized forms of forwards that trade on exchanges.
- Options – Give the holder the right to buy or sell the underlying asset on a fixed date in the future.
- Swaps – Contracts through which two parties exchange streams of cash flows.
This is the simplest type of derivatives. A forward contract is a private agreement between a buyer and a seller where the buyer commits to buy — and the seller commits to sell — an asset on a specified date in the future at a presently agreed price. The parties involved can customize the terms of their agreement and settlement process as they want.
The underlying asset can be a physical asset or tradable equity, and price movement of the asset determines who gains and who loses in the transaction. If the price goes up, the seller loses while the buyer gains because he gets the asset at a lower price than the market value.
Both parties may be using the contract for speculation or to hedge their exposure in the market. For instance, say the price of corn is $1020 per ton, and a corn farmer — whose cost of corn production is $850 per ton — is afraid that the price will fall below $850 per ton when his corns mature in four months’ time. At the same time, a supermarket distributor thinks that the price may get to $1200 per ton by then and cut into his profit margin.
The corn farmer may decide to enter a forward contract with a supermarket distributor to deliver 10 tons of corn in four months’ time at $1000 per ton. This helps the corn farmer lock in his profit and assures the supermarket distributor of corn supply at a reasonable price. If in four months’ time the price of corn is $1200, the distributor gains in getting a cheaper supply of corn, while the farmer lost out on the opportunity to gain more profits.
Forward contracts are traded over the counter, and being an OTC-traded derivative, there’s a higher degree of counterparty risk — a type of risk arising from the inability of either of the parties to meet the terms of the agreement.
A futures contract is similar to a forward contract because it is also an agreement for the exchange of an asset (commodity, stock, index, bond, and others) on a future date at a presently agreed price. However, futures are traded in the secondary market — the exchanges — and are highly standardized, with rules and regulations backed by the clearinghouse.
In futures contracts, both parties interact through their brokers and the clearinghouse. In other words, the buyer and the seller don’t enter into a private agreement. Instead, each party is in an agreement with the exchange. The exchange decides the size, format, and expiration of the contracts. So the agreement is not customizable.
Furthermore, both the buyer and the seller provide initial and maintenance margin, which determines the amount of leverage, and the exchange enforces a settlement procedure that usually involves daily settlements of gains and losses by the parties involved. This helps to reduce the chances of counterparty credit risk.
Just like forward contracts, a lot of investors use futures to hedge against their risk exposures, and they may prefer futures because of the lower default risk. Some may be using it for speculation, while others may just be arbitrage traders.
This is a contract which gives the investor the right to buy or sell a set amount of the underlying financial security at a pre-agreed price on or before the expiration of the contract. Options are mostly traded on the exchanges, although they can be traded over the counter.
The holder has the option to (or not) exercise the right, but the issuer is obligated to fulfill the contract if the holder chooses to exercise it. To have this special privilege, the holder has to pay the issuer a premium in advance. The amount of the premium is not directly related to the asset’s price.
An investor can buy a call or put option. A call option gives the holder the right to buy an asset from the issuer at a specified price on a later date (prior to expiry) while a put option allows the holder to sell an asset to the issuer at a specified price on a later date (prior to expiry).
Just like futures, options can be used to speculate on the price movement of the underlying instrument or to protect against price swings. For example, assuming an investor who owns 1000 shares of a stock trading at $10 per share is worried about possible price decline. He can decide to hedge his position by buying a put option at $10 strike price (say with $300 premium). If price later declines to $8 per share and he exercises his right to sell at $10 per share, he has prevented a $2000 (2×1000) loss with only $300!
Based on when the investor can exercise the option, there four types of options:
- American options: Can be exercised at any time until expiry
- European options: The buyer can exercise them on the day of expiry
- Bermuda options: Can be exercised only on a specified day
- Exotic options: Specialized options with unique payoff rules.
This is a type of derivative contract through which two parties can exchange their streams of cash flows within a specified period in the future. Swaps are about the most highly traded derivative and are mostly traded over the counter, making them highly customizable. But there are also standardized swaps that trade on the exchanges.
There are four types of swap contracts:
Interest Rate Swaps
This involves the exchange of one form of an interest rate for another, to reduce fluctuations in the rate or obtain a lower interest rate. It is used where an entity has access to a loan but doesn’t like the type of interest rate (floating or fixed). This entity can swap the interest rate payment with a willing party that has the preferred type of interest rate.
In this type of derivative contract, both the principal and interest payment in one currency are exchanged for the same in a different currency. This type of swap can be used to secure cheaper loans, as well as protect against fluctuations in the foreign exchange rate.
Credit Default Swap
Investors use this type to manage credit risks. A lender who is worried about getting back his money may sell the loan to an investor who is willing to assume the risk.
Total Return Swap
Here, one party pays the other (owner of the reference asset) an agreed rate over the life of the swap while receiving the income generated by a reference asset
Comparing the Four Basic Types of Derivatives
|Nature of contract||Both parties are obligated to fulfill the terms of the contract.||Both parties are obligated to fulfill the terms of the contract.||Only the issuer is obligated to keep to the terms of the contract. The holder can choose to exercise the right or not.||Both parties are obligated to keep to the terms of the contract.|
|Trading||Over the counter trading.||Traded in exchanges.||Mostly traded in exchanges.||Mostly traded over the counter, but there are exchange-traded swaps.|
|Fees||Just the agreed amount and probably legal fees.
|Commissions and brokerage fees.
Initial and maintenance margin.
|The holder pays a premium to the issuer to purchase the contract.
Of course, brokerage fees and commissions apply
|According to the agreement.
Brokerage fees may apply for exchange-traded swaps.
|Regulation||Unregulated||Regulated by the exchange’s clearing houses||Regulated by the exchanges.
Over-the-counter options aren’t regulated
Exchange-traded ones are regulated.
|Parties in the agreement||Direct agreement between two entities||No direct agreement between both parties
Instead, each party enters into an agreement with the exchange
|Exchange-backed agreement||Direct agreement between both parties. Exchange-traded swaps are backed by the exchange|
|Customizable contract||Yes||No, contracts are standardized||No, contracts are standardized||Yes.
But exchange-traded swaps are standardized.
|Settlement procedure||As agreed by both parties||Daily settlement procedure enforced by the exchange||The holder has the right to execute or not||As agreed by both parties|
|Level of risk||Counterparty default risk is high||Counterparty default risk is low||Counterparty default risk is low||Counterparty default risk is high|
There are hundreds, if not thousands, of derivatives in the market these days. But most of them are based on these four basic types. By learning these four, you can get a better understanding of the newer and more complex ones. Happy trading!