What is Derivatives?
A derivative is a financial contract with a value that is derived from an underlying asset. Derivatives have no direct value in and of themselves – their value is based on the expected future price movements of their underlying asset. The underlying asset can be equity, forex, commodity or any other asset.
For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying”.
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In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines “derivative” to include
- A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security.
- A contract which derives its value from the prices, or index of prices, of underlying securities.
Derivatives are often used as an instrument to hedge risk for one party of a contract, while offering the potential for high returns for the other party. Derivatives have been created to mitigate a remarkable number of risks such as fluctuations in stock, bond, commodity, and index prices; changes in foreign exchange rates; changes in interest rates; and weather etc.
A derivative is traded between two parties – who are referred to as the counterparties. These counterparties are subject to a preagreed set of terms and conditions that determine their rights and obligations.
Derivatives can be traded on or off an exchange and are known as
- Exchange-Traded Derivatives (ETDs): Standardised contracts traded on a recognised exchange, with the counterparties being the holder and the exchange. The contract terms are non-negotiable and their prices are publicly available.
Over-the-Counter Derivatives (OTCs): Bespoke contracts traded off-exchange with specific terms and conditions determined and agreed by the buyer and seller (counterparties). As a result OTC derivatives are more illiquid, eg forward contracts and swaps.
Types of Derivatives Contracts
The past few decades have witnessed a revolution in the trading of derivative securities in world financial markets. There is wide range of instruments available as derivatives. Every instrument has its own features and applicability.
The most common types of derivative contracts are:
A forward contract is a private agreement between two parties giving the buyer an obligation to purchase an asset (and the seller an obligation to sell an asset) at a set price at a future point in time. The party who agrees to buy the asset is called the long and the party selling the asset is called the short.
The assets often traded in forward contracts include commodities like grain, precious metals, electricity, oil, beef, orange juice, and natural gas, but foreign currencies and financial instruments are also part of today’s forward markets.
These financial instruments were devised to mitigate risk, by the way of securing buyers today for future produce. Parties involved in a forward contract have a contractual obligation to buy or sell the asset in question on maturity of the contract.
There are two ways in which this obligation can be met; delivery and cash settlement.
- Delivery: This is the case when the long pay the short the agreed-upon amount, in exchange, the short will deliver the asset to the long. This type of forward is typically called a deliverable forward.
- Cash settlement: Cash settlement is when the parties agree to calculate the market value of the position at expiry and payment is made to the long. A forward contract involving a cash settlement is called a non-deliverable forward.
A futures contract is an agreement between two parties – a buyer and a seller – to buy or sell something at a future date. The contact trades on a futures exchange and is subject to a daily settlement procedure.
Future contracts evolved out of forward contracts and possess many of the same characteristics. Unlike forward contracts, futures contracts trade on organized exchanges, called future markets.
Future contacts also differ from forward contacts in that they are subject to a daily settlement procedure. In the daily settlement, investors who incur losses pay them every day to investors who make profits. In every futures contract, everything is specified: the quantity and quality of the commodity, the specific price per unit, and the date and method of delivery.
The “price” of a futures contract is represented by the agreed-upon price of the underlying commodity or financial instrument that will be delivered in the future
Essentially a Futures contract has following features:
- The buyer of a futures contract, the “long,” agrees to receive delivery;
- The seller of a futures contract, the “short,” agrees to make delivery;
- The contracts are traded on exchanges either by open outcry in specified trading areas (called pits or rings) or electronically via a computerized network;
- Futures contracts are marked to market each day at their end-of-day settlement prices, and the resulting daily gains and losses are passed through to the gaining or losing accounts;
- Futures contracts can be terminated by an offsetting transaction (i.e., an equal and opposite transaction to the one that opened the position) executed at any time prior to the contract’s expiration. The vast majority of futures contracts are terminated by offset or a final cash payment rather than by delivery; and
- The same or similar futures contracts can be traded on more than one exchange in the United States or elsewhere, although normally one contract tends to dominate its competitors on other exchanges in terms of trading activity and liquidity.
An options contract is an agreement between a buyer and seller that gives the purchaser of the option the right, but not the obligation to buy or sell a particular asset at a later date at an agreed upon price.
Options contracts are often used in securities, commodities, and real estate transactions. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted upon. Contracts also have an expiration date. When an option expires, it no longer has value and no longer exists.
Option contracts are either put or call options:
- Call Option. The owner of a Call Option has the right to purchase the underlying good at a specific price, and this right lasts until a specific date.
- Put Option. The owner of a Put Option has the right to sell the underlying good at a specific price, and this right lasts until a specific date.
Features of an options contract
- The buyer has the right to buy or sell the asset.
- To acquire the right of an option, the buyer of the option must pay a price to the seller. This is called the option price or the premium.
- The exercise price is also called the fixed price, strike price or just the strike and is determined at the beginning of the transaction. It is the fixed price at which the holder of the call or put can buy or sell the underlying asset.
- Exercising is using this right the option grants you to buy or sell the underlying asset. The seller may have a potential commitment to buy or sell the asset if the buyer exercises his right on the option.
- The expiration date is the final date that the option holder has to exercise her right to buy or sell the underlying asset.
- An American option can be exercised at any time, whereas a European option can only be exercised at the expiration date.
Swaps are agreements between two companies to exchange cash flows in the future accordig to a prearranged formula. Swaps, therefore, may be regarded as a portfolio of forward contra.
Swaps are traded on overthecounter derivatives markets and are most common in interest rates, currencies and commodities. They often extend much further into the future than exchange contracts.
The two commonly used swaps are:
- Interest rate swaps: An interest rate swap is an agreement between two parties to exchange one stream of interest payments for another, over a set period of time.
In an interest rate swap, the principal amount is not actually exchanged between the counterparties, rather interest payments are exchanged based on a ‘notional amount’ or ‘notional principal’.
- Currency swaps: A currency swap is a contract which commits two counter parties to an exchange, over an agreed period, two streams of payments in different currencies, each calculated using a different interest rate, and an exchange, at the end of the period, of the corresponding principal amounts, at an exchange rate agreed at the start of the contract.