Warren Buffett calls them “the financials weapons of mass destruction”.
Judd Gregg terms them as “a huge, complex issue”.
Derivative securities were blamed for bloodshed on the Wall Street in 2008, but they came into existence for overcoming the very volatility in the markets they are known to instill.
In this post, we will understand the very basics of financial derivatives – their rationality, utility and the different forms in which they exist. Let’s start then.
What’s a Derivative ?
A derivative is an instrument whose value is dependent on an underlying security. This security may either be a financial asset or a commodity. Instruments based on former are called Financial derivatives and those based on latter are Commodity derivatives. It needs to be understood that a derivative in itself is only a contract and not a product. Its value changes with fluctuations in the price of the underlying.
Most common financial underlying are stocks, bonds, market indices, interest rates and currencies.
Rational behind their existence –
The BSE introduced the derivative contracts on June 9, 2000. Through 2001-02, Indian markets got a further taste of index options, stock options and single stock futures. Following are the benefits which are advocated in favour of derivative contracts –
- Reduce risk
- Help in price discovery of underlying security
- Greater liquidity and lower transaction cost
- Speculation, arbitrage and hedge
- Encourage competition
- Channel savings into investments
OTC (Over the Counter) vs Exchange Traded –
OTC derivatives are directly between two parties, without any intermediary facilitating the transaction. It is entered into privately and can be customised suiting the needs of the two parties. As such contracts are unregulated there is a higher counter-party risk. Eg: Forwards, Swaps (We will come to them in a while)
Exchange traded derivatives, on the other hand, are highly regulated and available for trade at sophisticated exchanges. They are very liquid, transparent, standardised and secure. Presence of a clearing house and margin requirements ensure the performance of the contract and its credibility. Eg: Futures, Options (Yes, we are coming to them)
Note: All the contracts available on NSE and BSE are exchange traded derivatives.
Hedgers, speculators and arbitrageurs make up the derivative segment.
- Hedgers are entities who enter to protect their business risks. They participate to insure their positions against steep market fluctuations. They essentially enter to reduce risk.
- Speculators are present to pursue profits, accepting risk in their approach. They provide market depth and liquidity.
- Arbitrageurs participate to make security mispricing work to their advantage. They facilitate price discovery, stability and liquidity.
Now that we are familiar with background of a Derivative Market, we can now explore the types of derivatives and their functioning-
Derivatives are primarily take four forms in the markets – As Forward, Futures, Options and Swap contracts
Types of Derivative contracts
1) Forward Contracts –
It is a non- standardised contract, where one party commits to buy and the other to sell a specified amount of security at an agreed price (delivery price/ forward price) on a specific date in future (expiry date). It is a customised contract and not freely tradable over the bourses, thus, it is and OTC derivative. These are settled through actual delivery. Highly illiquid, they are exposed to major counter-party risk due to the absence of a regulatory body.
Example of a forward contract
Note: These are not entered into by ordinary investors/speculators like me and you (unless you are an actual businessman dealing in goods)
2) Futures Contracts –
It is a standardized contract between two parties to exchange a specified asset of standardized quantity for a price agreed today (strike price) with delivery occurring at a specified future date (expiry date). Since such contract is traded through exchange, it is an exchange traded derivative. Such contracts are highly liquid, with next to zero credit risk due to the presence of a clearing agent. The default risk is mitigated by putting up an initial amount of cash, called margin. Margin helps ensure that there is sufficient cash in account to make up for a loss making position. Such contracts are marked to market daily, and thus profit or loss position is available on a day-to-day basis. They are highly popular in Indian markets.
Example of a futures contract
Following are the main points of difference between forward and futures contracts.
3) Options –
These are contracts that give the holder the option to buy/ sell specified quantity of the underlying assets at a particular price (strike price) on or before a specified time period (expiry date). Option buyer earns the right, but not the obligation, to engage in that transaction, while the option seller has the obligation upon him to meet the transaction in case option buyer exercises his right. Option seller earns a premium (borne by the option buyer) for undertaking the obligation.
They too are exchange traded derivatives.
Types of Options – call and put
Call option – It gives the buyer the right to buy but not the obligation to buy a given quantity of the underlying asset, at a given price (strike price/ exercise price) on or before a particular date (expiry date) by paying a premium to call seller.
Understanding a Call option
Put option– It gives the buyer the right to sell, but not obligation to sell a given quantity of the underlying asset at a given price (strike price/ exercise price) on or before a particular date (expiry date) by paying a premium to put seller.
Understanding a Put option
4) Swaps –
It involves exchange of benefits of one party’s financial instrument for those of the other party’s financial instrument. Parties enter a contract agreeing to exchange cash flows from each other’s instruments on an agreed date. They are mostly OTCs. There are mainly two types of swaps – interest rate swaps and currency swaps. While interest rate swaps are used to hedge fixed rate and variable rate obligations, currency swaps help in benefitting from lower cost of borrowing, of desired currency, in other markets.
So, this is the crux of derivative markets. I know, for a stranger to markets, it would not be so easy to grasp at one go. But hey, don’t lose heart, let the terms sink in. In the end, it is worth knowing them, very literally!
Leave your comments below for suggestions and questions.
Thanks to slideshare.com for the wonderful examples.