Derivatives-basics

DERIVATIVES

A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Because derivatives are just contracts, just about anything can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.  Derivatives are generally used to hedge risk, but can also be used for speculative purposes. For example, a European investor purchasing shares of an American company off of an American exchange (using American dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros.

TYPES OF DERIVATIVES

FORWARD CONTRACTS

A cash market transaction in which delivery of the commodity is deferred until after the contract has been made. Although the delivery is made in the future, the price is determined on the initial trade date. Most forward contracts don’t have standards and aren’t traded on exchanges. A farmer would use a forward contract to “lock-in” a price for his grain for the upcoming fall harvest.

FUTURES CONTRACT

In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. A futures contract gives the holder the obligation to buy or sell, which differs from an options contract, which gives the holder the right, but not the obligation. In other words, the owner of an options contract may exercise the contract. Both parties of a “futures contract” must fulfill the contract on the settlement date. The seller delivers the commodity to the buyer, or, if it is a cash-settled future, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset their position by either selling a long position or buying back a short position, effectively closing out the futures position and its contract obligations.  Futures contracts, or simply futures, are exchange traded derivatives. The exchange’s clearinghouse acts as counterparty on all contracts, sets margin requirements, etc.

OPTIONS

An option contract has an exceptional characteristic distinguishing it from any other financial instrument – the holder or owner of an option has the right, but does not have an obligation to buy or sell an underlying instrument at a predetermined price during a specific period or at a specific time. If a person buys a Mercedes, and his best friend wants to buy the car from him, the owner can give his best friend the option to buy the car from him at the date when he wants to sell the car, at a certain price. There are two basic types of options: An option to buy something, such as the example above. This is known as a call option. An option to sell something. This is called a put option.  The formal definition of a call option would be that it grants the buyer the right but does not confer an obligation to purchase a certain quantity of the underlying asset at a predetermined price.  The price at which the purchase of the underlying asset will take place if the option is exercised is called the strike price, and this is decided at the initial closing of the option contract.  The amount or-price paid for the option when the option is bought, is called the option premium.  Likewise, a put option would grant the buyer the right but does not impose an obligation to sell the underlying instrument at a predetermined price.  A further parameter of an option is the period that the holder has to exercise the option. An American option can be exercised and settled at any time up to the expiry date. A European option can only be exercised using the market prices valid on expiry date and is settled on or within a short time after the expiry date.

SWAPS

Traditionally, the exchange of one security for another to change the maturity (bonds), quality of issues (stocks or bonds), or because investment objectives have changed. Recently, swaps have grown to include currency swaps and interest rate swaps. If firms in separate countries have comparative advantages on interest rates, then a swap could benefit both firms. For example, one firm may have a lower fixed interest rate, while another has access to a lower floating interest rate. These firms could swap to take advantage of the lower rates.