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Basics of Derivatives

    Mr. Vinod Kumar. K | Saturday, November 20,2010, 05:01 PM
 

A derivative is an instrument whose value is derived from the value of one or more underlying asset, which can be stocks, bonds, currency, commodities, metals, intangible pseudo assets like stock indices etc. When we say a Tata Steel future or a Tata Steel option, these carry a value only because of the value of Tata Steel. Below given are the four most common types of derivative instruments.

  • Forwards
  • Futures
  • Options
  • Swaps

Financial Derivatives

Financial derivatives are instruments, which derive their value from financial assets. These derivatives can be forward rate agreements, futures, options swaps etc. As mentioned earlier, the most traded instruments are futures and options. Assets under financial derivatives can be the following;

  • Stocks
  • Bonds
  • Currency etc.

Pricing of Derivatives

Derivative is priced based on a future price of the underlying asset i.e.; perceived value of the asset. In the case of an option to buy an asset at some future date, the expectation is that it will be priced higher than the derivative price plus the strike price (the price you agree to pay), allowing for a gain. For example, Lets consider the underlying asset as a stock, if Stock XYZ is trading at Rs. 500 and you buy an option for Rs.100, allowing you to purchase XYZ at Rs. 1000 at some future date, your expectation is that XYZ will be at Rs. 1100 or higher by that future date.

Why Derivatives are Risky?

In the example above, the risk lies in the fact that XYZ might not reach Rs.1100 by the future date mentioned in the contract. If it does not reach Rs. 1100, you would not exercise your option. You paid Rs. 100 for that option that you will not have had the opportunity to use. Of course, Rs. 100 is not a huge amount, but when you multiply that by thousands, it becomes more substantial.

How do People Make Money with Derivatives?

When we consider derivatives trading there are two categories of people, those who make money and those who lose money. The people who make money with derivatives are on the opposite side of the transaction of someone who loses money. In the above example, if you bought an option to purchase XYZ at Rs. 1000 and you paid Rs.100 for that option, the person who gets Rs.100 makes money. That person will also get to keep ABC stock if it does not reach Rs.1000. Therefore, if XYZ is priced at Rs. 500 when the derivative is sold and it only makes it to Rs.900 by the strike date, then the person who sold the option makes Rs. 100 on the option sale and will have enjoyed an unrealized gain of Rs.400 (900-500=400) on the underlying ABC security.

The basic objective of derivatives trading is to generate income and to hedge against potential losses. By considering the chances of huge loss using of derivative products should only be considered by educated and high net worth investors, or speculators who are comfortable with the complete, potential loss.

Who use derivatives?

Derivatives will find use for the following set of people :

Speculators


Speculators are those people who buy or sell in the market to make profits. For instance, if you will the stock price of Reliance is expected to go upto Rs.400 in 1 month, one can buy a 1 month future of Reliance at Rs 350 and make profits.

Hedgers


Hedgers are those people who buy or sell to minimize their losses. For instance, an importer has to pay US $ to buy goods and rupee is expected to fall to Rs 48/$ from Rs 45/$, then the importer can minimize his losses by buying a currency future at Rs 46/$·

Arbitrageurs


Arbitrageurs are those people who buy or sell to make money on price differentials in different markets. In other words arbitraging helps us to take advantage of a price difference between two or more markets. Difference between the market prices is the profit. For instance, a futures price is simply the current price plus the interest cost. If there is any change in the interest, it shows an arbitrage opportunity.

Terminologies used in a Futures contract

The terminologies used in a futures contract are :

  • Spot Price: The current market price of the scrip/index
  • Future Price: The price at which the futures contract trades in the futures market
  • Tenure: The period for which the future is traded
  • Expiry date: The date on which the futures contract will be settled
  • Basis: The difference between the spot price and the future price

Forward contracts

A forward contract is a customized contract between two parties, where settlement takes place on a specific date in future at a price agreed today. The main features of forward contracts are;

  • They are bilateral contracts and hence exposed to counter party risk.
  • Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.
  • The contract price is generally not available in public domain.
  • The contract has to be settled by delivery of the asset on expiration date.
  • In case, the party wishes to reverse the contract, it has to compulsorily go to the same counter party, which being in a monopoly situation can command the price it wants.

Futures

Futures are exchange-traded contracts to sell or buy the underlying asset; it can be financial instruments or physical commodities for Future delivery at an agreed price. There is an agreement to buy or sell a specified quantity of financial instrument/ commodity in a designated future month at a price agreed upon by the buyer and seller. To make trading possible, the exchange specifies certain standardized features of the contract.

  • Future contracts are standardised contracts, which are traded on the exchanges.
  • These contracts, being standardised and traded on the exchanges are very liquid
  • In futures market, clearing corporation/ house provides the settlement guarantee.

Difference between Forward & Futures contract

Futures

Forward

Traded on organized exchange

Over the Counter

Standardized

Customised

Liquidity is more

Liquidity is Less

Requires Margin Payments

Not required

Follows daily settlement

At the end of the period

Can be reversed with any member of the exchange

Contract can be reversed only with the same counter-party with whom it was entered into.

Options

Options contracts are those which give only the right to buy or sell the underlying asset, whereas futures contract have the obligation to buy or sell the underlying asset. The buyer of the options contract has the right to choose whether or not to exercise their right, and if they do, the seller of a matching options contract will be obligated to complete the transaction. There are two main types of options;

  • Call Option
  • Puts Option

Calls Option


Calls Option gives you the right to buy the underlying asset in a future date. You can buy a call option when you believe the underlying futures price will move higher. For example, if you expect Nifty futures to move higher, you should buy a Nifty call option.

Puts Option


Put Option gives you the right to sell the underlying asset in a future date. It is better to buy a put option if you believe the underlying futures price will move lower. For example, if you expect Nifty futures to move lower, you should buy a Nifty put option.

Terminologies used in options

  • Option holder: The buyer of the option who gets the right
  • Option writer: The seller of the option who carries the obligation
  • Premium: The consideration paid by the buyer for the right
  • Exercise price/ strike price: Price at which the option holder has the right to buy or sell.
  • Call option: The option that gives the holder a right to buy
  • Put option: The option that gives the holder a right to sell
  • Tenure: The period for which the option is issued
  • Expiration date: The date on which the option is to be settled
  • American option: Options that can be exercised at any point till the expiration date
  • European option: These are options that can be exercised only on the expiration date
  • Covered option: An option that an option writer sells when he has the underlying shares with him.
  • Naked option: An option that an option writer sells when he does not have the underlying shares with him.
  • In the money: An option is in the money if the option holder is making a profit if the option was exercised immediately
  • Out of money: An option is in the money if the option holder is making a loss if the option was exercised immediately
  • At the money: An option is in the money if the option holder evens out if the option was exercised immediately

Swaps

Swap is a financial derivative contract where a set of future cash flows are agreed to be exchanged between two counterparties at set dates in the future. In other words swap is a derivative instrument in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The swap agreement defines the dates when the cash flows are to be paid and the way they are calculated. Following are the major kinds of swaps;

  • Interest rate swaps
  • Currency swaps
  • Commodity swaps
  • Equity Swap
  • Credit default swap

Mr. Vinod Kumar. K

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