Derivatives

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Derivative

What Is a Derivative?

A derivative is a financial security with a value that is reliant upon or derived from, an underlying asset or group of assets—a benchmark. The derivative itself is a contract between two or more parties, and the derivative derives its price from fluctuations in the underlying asset.

The most common underlying assets for derivatives are stocks, bonds, commodities, currencies, interest rates, and market indexes. These assets are commonly purchased through brokerages.

(See how your broker compares with Investopedia list of the best online brokers).

Derivatives can trade over-the-counter (OTC) or on an exchange. OTC derivatives constitute a greater proportion of the derivatives market. OTC-traded derivatives, generally have a greater possibility of counterparty risk. Counterparty risk is the danger that one of the parties involved in the transaction might default. These parties trade between two private parties and are unregulated.

Conversely, derivatives that are exchange-traded are standardized and more heavily regulated.

Derivative: My Favorite Financial Term

The Basics of a Derivative

Derivatives can be used to hedge a position, speculate on the directional movement of an underlying asset, or give leverage to holdings. Their value comes from the fluctuations of the values of the underlying asset.

Originally, derivatives were used to ensure balanced exchange rates for goods traded internationally. With the differing values of national currencies, international traders needed a system to account for differences. Today, derivatives are based upon a wide variety of transactions and have many more uses. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a region.

For example, imagine a European investor, whose investment accounts are all denominated in euros (EUR). This investor purchases shares of a U.S. company through a U.S. exchange using U.S. dollars (USD). Now the investor is exposed to exchange-rate risk while holding that stock. Exchange-rate risk the threat that the value of the euro will increase in relation to the USD. If the value of the euro rises, any profits the investor realizes upon selling the stock become less valuable when they are converted into euros.

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To hedge this risk, the investor could purchase a currency derivative to lock in a specific exchange rate. Derivatives that could be used to hedge this kind of risk include currency futures and currency swaps.

A speculator who expects the euro to appreciate compared to the dollar could profit by using a derivative that rises in value with the euro. When using derivatives to speculate on the price movement of an underlying asset, the investor does not need to have a holding or portfolio presence in the underlying asset.

Key Takeaways

  • Derivatives are securities that derive their value from an underlying asset or benchmark.
  • Common derivatives include futures contracts, forwards, options, and swaps.
  • Most derivatives are not traded on exchanges and are used by institutions to hedge risk or speculate on price changes in the underlying asset.
  • Exchange-traded derivatives like futures or stock options are standardized and eliminate or reduce many of the risks of over-the-counter derivatives
  • Derivatives are usually leveraged instruments, which increases their potential risks and rewards.

Common Forms of Derivatives

There are many different types of derivatives that can be used for risk management, for speculation, and to leverage a position. Derivatives is a growing marketplace and offer products to fit nearly any need or risk tolerance.

Futures

Futures contracts—also known simply as futures—are an agreement between two parties for the purchase and delivery of an asset at an agreed upon price at a future date. Futures trade on an exchange, and the contracts are standardized. Traders will use a futures contract to hedge their risk or speculate on the price of an underlying asset. The parties involved in the futures transaction are obligated to fulfill a commitment to buy or sell the underlying asset.

For example, say that Nov. 6, 2020, Company-A buys a futures contract for oil at a price of $62.22 per barrel that expires Dec. 19, 2020. The company does this because it needs oil in December and is concerned that the price will rise before the company needs to buy. Buying an oil futures contract hedges the company’s risk because the seller on the other side of the contract is obligated to deliver oil to Company-A for $62.22 per barrel once the contract has expired. Assume oil prices rise to $80 per barrel by Dec. 19, 2020. Company-A can accept delivery of the oil from the seller of the futures contract, but if it no longer needs the oil, it can also sell the contract before expiration and keep the profits.

In this example, it is possible that both the futures buyer and seller were hedging risk. Company-A needed oil in the future and wanted to offset the risk that the price may rise in December with a long position in an oil futures contract. The seller could be an oil company that was concerned about falling oil prices and wanted to eliminate that risk by selling or “shorting” a futures contract that fixed the price it would get in December.

It is also possible that the seller or buyer—or both—of the oil futures parties were speculators with the opposite opinion about the direction of December oil. If the parties involved in the futures contract were speculators, it is unlikely that either of them would want to make arrangements for delivery of several barrels of crude oil. Speculators can end their obligation to purchase or deliver the underlying commodity by closing—unwinding—their contract before expiration with an offsetting contract.

For example, the futures contract for West Texas Intermediate (WTI) oil trades on the CME represents 1,000 barrels of oil. If the price of oil rose from $62.22 to $80 per barrel, the trader with the long position—the buyer—in the futures contract would have profited $17,780 [($80 – $62.22) X 1,000 = $17,780]. The trader with the short position—the seller—in the contract would have a loss of $17,780.

Not all futures contracts are settled at expiration by delivering the underlying asset. Many derivatives are cash-settled, which means that the gain or loss in the trade is simply an accounting cash flow to the trader’s brokerage account. Futures contracts that are cash settled include many interest rate futures, stock index futures, and more unusual instruments like volatility futures or weather futures.

Forwards

Forward contracts—known simply as forwards—are similar to futures, but do not trade on an exchange, only over-the-counter. When a forward contract is created, the buyer and seller may have customized the terms, size and settlement process for the derivative. As OTC products, forward contracts carry a greater degree of counterparty risk for both buyers and sellers.

Counterparty risks are a kind of credit risk in that the buyer or seller may not be able to live up to the obligations outlined in the contract. If one party of the contract becomes insolvent, the other party may have no recourse and could lose the value of its position. Once created, the parties in a forward contract can offset their position with other counterparties, which can increase the potential for counterparty risks as more traders become involved in the same contract.

Swaps

Swaps are another common type of derivative, often used to exchange one kind of cash flow with another. For example, a trader might use an interest rate swap to switch from a variable interest rate loan to a fixed interest rate loan, or vice versa.

Imagine that Company XYZ has borrowed $1,000,000 and pays a variable rate of interest on the loan that is currently 6%. XYZ may be concerned about rising interest rates that will increase the costs of this loan or encounter a lender that is reluctant to extend more credit while the company has this variable rate risk.

Assume that XYZ creates a swap with Company QRS, which is willing to exchange the payments owed on the variable rate loan for the payments owed on a fixed rate loan of 7%. That means that XYZ will pay 7% to QRS on its $1,000,000 principal, and QRS will pay XYZ 6% interest on the same principal. At the beginning of the swap, XYZ will just pay QRS the 1% difference between the two swap rates.

If interest rates fall so that the variable rate on the original loan is now 5%, Company XYZ will have to pay Company QRS the 2% difference on the loan. If interest rates rise to 8%, then QRS would have to pay XYZ the 1% difference between the two swap rates. Regardless of how interest rates change, the swap has achieved XYZ’s original objective of turning a variable rate loan into a fixed rate loan.

Swaps can also be constructed to exchange currency exchange rate risk or the risk of default on a loan or cash flows from other business activities. Swaps related to the cash flows and potential defaults of mortgage bonds are an extremely popular kind of derivative—a bit too popular. In the past. It was the counterparty risk of swaps like this that eventually spiraled into the credit crisis of 2008.

Options

An options contract is similar to a futures contract in that it is an agreement between two parties to buy or sell an asset at a predetermined future date for a specific price. The key difference between options and futures is that, with an option, the buyer is not obliged to exercise their agreement to buy or sell. It is an opportunity only, not an obligation—futures are obligations. As with futures, options may be used to hedge or speculate on the price of the underlying asset.

Imagine an investor owns 100 shares of a stock worth $50 per share they believe the stock’s value will rise in the future. However, this investor is concerned about potential risks and decides to hedge their position with an option. The investor could buy a put option that gives them the right to sell 100 shares of the underlying stock for $50 per share—known as the strike price—until a specific day in the future—known as the expiration date.

Assume that the stock falls in value to $40 per share by expiration and the put option buyer decides to exercise their option and sell the stock for the original strike price of $50 per share. If the put option cost the investor $200 to purchase, then they have only lost the cost of the option because the strike price was equal to the price of the stock when they originally bought the put. A strategy like this is called a protective put because it hedges the stock’s downside risk.

Alternatively, assume an investor does not own the stock that is currently worth $50 per share. However, they believe that the stock will rise in value over the next month. This investor could buy a call option that gives them the right to buy the stock for $50 before or at expiration. Assume that this call option cost $200 and the stock rose to $60 before expiration. The call buyer can now exercise their option and buy a stock worth $60 per share for the $50 strike price, which is an initial profit of $10 per share. A call option represents 100 shares, so the real profit is $1,000 less the cost of the option—the premium—and any brokerage commission fees.

In both examples, the put and call option sellers are obligated to fulfill their side of the contract if the call or put option buyer chooses to exercise the contract. However, if a stock’s price is above the strike price at expiration, the put will be worthless and the seller—the option writer—gets to keep the premium as the option expires. If the stock’s price is below the strike price at expiration, the call will be worthless and the call seller will keep the premium. Some options can be exercised before expiration. These are known as American-style options, but their use and early exercise are rare.

Advantages of Derivatives

As the above examples illustrate, derivatives can be a useful tool for businesses and investors alike. They provide a way to lock in prices, hedge against unfavorable movements in rates, and mitigate risks—often for a limited cost. In addition, derivatives can often be purchased on margin—that is, with borrowed funds—which makes them even less expensive.

Downside of Derivatives

On the downside, derivatives are difficult to value because they are based on the price of another asset. The risks for OTC derivatives include counter-party risks that are difficult to predict or value as well. Most derivatives are also sensitive to changes in the amount of time to expiration, the cost of holding the underlying asset, and interest rates. These variables make it difficult to perfectly match the value of a derivative with the underlying asset.

What Is a Derivative, and How Does It Work?

The term derivative is often defined as a financial product—securities or contracts—that derive their value from their relationship with another asset or stream of cash flows. Most commonly, the underlying element is bonds, commodities, and currencies, but derivatives can assume value from nearly any underlying asset.

What Is a Derivative?

There are many types of derivatives and they can be good or bad, used for productive things or as speculative tools. Derivatives can help stabilize the economy or bring the economic system to its knees in a catastrophic implosion. An example of derivatives that were flawed in their construction and destructive in their nature are the infamous mortgage-backed securities (MBS) that brought on the subprime mortgage meltdown of 2007 and 2008.

Typically, derivatives require a more advanced form of trading. They include speculating, hedging, and trading in commodities and currencies through futures contracts, options swaps, forward contracts, and swaps. When used correctly, they can supply benefits to the user. However, there are times that the derivatives can be destructive to individual traders as well as large financial institutions.

Common Types of Derivatives

Derivatives can be bought through a broker—standardized—and over-the-counter (OTC)—non-standard contracts. Counterparty risk is associated with derivative trading. This risk is the chance that the opposing party in a trade—deal—will not hold up their end of the contract. Derivatives can be traded as:

  • Future contracts
  • Forward contracts
  • Options contracts
  • Swaps
  • Contracts for difference (CFD)

Futures Contracts

While futures contracts exist on all sorts of things, including stock market indices such as the S&P 500 or The Dow Jones Industrial Average, futures are predominately used in the commodities markets. These are all standardized—price, date, and lot size—and trade through an exchange. Also, all contracts settle daily. Unless the trader buys an offsetting trade, they have the obligation to buy or sell the underlying asset. Futures are frequently used for speculation.

Imagine you own a farm. You grow a lot of corn, so you need to be able to estimate your total cost structure, profit, and risk. You can go to the futures market and sell a contract to deliver your corn, on a certain date and at a pre-agreed upon price. The other party can buy that futures contract and, in many cases, require you to physically deliver the corn. For example, Kellogg’s or General Mills, two of the world’s largest cereal makers, might buy corn futures to guarantee they have sufficient upcoming raw corn to manufacturer cereal while simultaneously budgeting their expense levels so they can forecast earnings for management to make plans.

Forward Contracts

Forward contracts function much like futures. However, these are non-standardized contracts and trade OTC. Since they are non-standard the two parties can customize the elements of the contract to suit their needs. Forward contracts are valuable for hedging future costs. These contracts settle at the expiration—or end date. Like futures, there is an obligation of the party to buy or sell the underlying asset at the given date and price.

Airlines use futures to hedge their jet fuel costs, mining companies can sell futures to provide greater cash flow stability and know what they will get for their gold or other commodities, and ranchers can sell futures for their cattle. These contracts transfer the risk between willing parties leading to greater efficiency and desirable outcomes.

Derivative Options

Options give the trader just that, an option. They have the ability to buy or sell a particular asset for the agreed-upon price on or before—depending on if it is an American or European option—the expiration date. Options can get quite complex in the structure of calls and puts. Call options and put options, which can be used conservatively or as extraordinarily risky gambling mechanisms are an enormous market. Options trade on primarily on exchanges as standardized contracts, but you will find exotic options that trade OTC.

Practically all major publicly traded corporations in the United States have listed call options and put options. While they can be extremely risky for the individual trader, from a system-wide stability standpoint, exchange-traded derivatives such as this are among the least worrisome because the buyer and seller of each option contract enter into a transaction with the options exchange, who becomes the counterparty.

The options exchange guarantees the performance of each contract and charges fees for each transaction to build what amounts to a type of insurance pool to cover any failures that might arise. If the person on the other side of the trade gets in trouble due to a wipeout margin call, the other person won’t even know about it.

Swaps

Companies, banks, financial institutions, and other organizations routinely enter into derivative contracts known as interest rate swaps or currency swaps. These are meant to reduce risk. They can effectively turn fixed-rate debt into floating-rate debt or vice versa. They can reduce the chance of a major currency move making it much harder to pay off a debt in another country’s currency. The effect of swaps can be considerable on the balance sheet and income results in any given period as they serve to offset and stabilize cash flows, assets, and liabilities (assuming they are properly structured).

Contracts for Difference (CFD)

CFDs work like the futures contracts listed above in most regards. Here, the two parties agree that the selling party will pay the difference in the value of an underlying asset at the closing of the contract to the buyer. This contract is a cash-settled deal and no physical commodities or goods will trade hands. CFD trades are not allowed in the U.S.

Subprime Derivatives

During the subprime meltdown, the inability to identify the real risks of investing in MBS—and other such securities—and properly protect against them caused a “daisy-chain” of events. This is where interconnected corporations, institutions, and organizations find themselves instantaneously bankrupt as a result of a poorly written or structured derivative position with another firm that failed, or in other words, a domino effect.

A major reason this danger is built into derivatives is because of counter-party risk. Most derivatives are based on the person or institution on the other side of the trade being able to live up to their end of the deal that was struck.

If society allows people to use leverage to enter into all sorts of complex derivative arrangements, we could find ourselves in a scenario where everybody carries large values of derivative positions on their books only to find—when it’s all unraveled—that there is very little actual value.

The problem becomes exacerbated because many privately written derivative contracts have built-in collateral calls that require a counterparty to put up more cash or collateral at the very time they are likely to need all the money they can get, accelerating the risk of bankruptcy. It is for this reason that billionaire Charlie Munger, longtime a critic of derivatives, calls most derivative contracts “good until reached for” as the moment you need to grab the money, it could very well evaporate on you no matter what you’re carrying it at on your balance sheet.

Munger and his business partner Warren Buffett famously get around this by only allowing their holding company, Berkshire Hathaway, to write derivative contracts in which they hold the money and under no condition can they be forced to post more collateral along the way.

Derivatives

07 April, 2020, 10:38 PM IST
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Definition of ‘Derivatives’

Definition: A derivative is a contract between two parties which derives its value/price from an underlying asset. The most common types of derivatives are futures, options, forwards and swaps.

Description: It is a financial instrument which derives its value/price from the underlying assets. Originally, underlying corpus is first created which can consist of one security or a combination of different securities. The value of the underlying asset is bound to change as the value of the underlying assets keep changing continuously.

Generally stocks, bonds, currency, commodities and interest rates form the underlying asset.

What are Derivatives? Watch video to know more.

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