Learn the basics of Derivatives

Derivatives: A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset (like a security) or set of assets (like an index). Common underlying instruments include bonds, commodities, currencies, interest rates, market indexes and stocks

There are mainly four types of derivative contracts. They are futures, forwards, options & swaps

Future Contracts:

A future contract is similar to a forward contract which is standardized and is exchange traded. Futures remove the inefficiencies of forward contracts such as they are not exposed to counterparty risk of defaulting and are also much more liquid. The standardization of the contract is with respect to the Quality of underlying asset, and the terms of the contract (covenants)

Let us understand it with the help of an illustration of a Futures contract. What does the statement – ‘X” has bought 1 lot (250 shares) of ABC co. July Future @ $700 mean in theory?

 It means that the person has agreed to buy 250 shares of ABC CO. on July20XX (the expiration date) at $ 700 per share.

 Here, the underlying asset is the shares of ABC CO. shares .The quantity is 1 lot, i.e. 250 shares. The expiry date is July 20XXand, the pre-determined price is $ 700 (and is called the Strike Price)

If the actual price of the company is $800 on the settlement day (July), the person buys 250 shares at the contracted price of $ 700 and may sell it at the prevailing market price of $ 800 thereby gaining $100 per share ($ 25,000 in total).

On the other hand if the price falls to 650 he loses $ 50 per share ($12,500 in total) as he has to buy at $ 700 but the prevailing market price is $650.

Forward Contracts:

A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. The main features of this definition are

There is an agreement

Agreement is to buy or sell the underlying asset

The transaction takes place on a predetermined future date

The price at which the transaction will take place is also predetermined

Let us illustrate it with an example. Suppose an IT company exports its services to US and hence earns its revenue in Dollars. If it knows it would receive a payment of $1 million in six months’ time, it cannot be sure as to what would be the yen value of this $1 million after six months. Assuming that the current rate is ¥ 43/$, the value as per current rate would be ¥43 million. Now suppose the actual forex rate after six months is ¥37/$ and hence the company receives ¥ 37 million which is less by almost 14% that the current value.

In the reverse scenario of yen depreciating vis-à-vis the dollar, a rate of ¥ 45/$ would lead to a gain of ¥ 2 million.

Hence, the company is exposed to currency risk. To hedge this risk, the company may sell dollar forward i.e. it may enter into an agreement to sell $1 mn after 6 months at a rate of ¥43/$.

Note that it satisfies all the conditions of a forward contract.

One pre-requisite of a forward contract is that there should be another party which is willing to take a reverse position. For example, in the above case we may sell dollars forward only if someone is willing to buy it after six months. An importer who purchases goods and hence makes payment in dollars might need to hedge his currency risk by being the other side of this contract.

Option Contracts:

An option is a contract which gives one party the right to buy or sell the underlying asset on a future date at a pre-determined price and not the necessity to do. The other party has the obligation to sell/buy the underlying asset at this pre-determined price (called the strike price). The option which gives the right to buy is called the CALL option while the option which gives the right to sell is called the PUT option. Let us consider a few examples: -

i) Buyer of Nifty July Call option of strike 4500: It gives the right to buy Nifty at 4500

ii) Buyer of Infosys July Put option of strike 1550: It gives the right to sell Infosys at 1550

iii) Seller of Nifty July Call option of strike 4500: The seller has the obligation to sell Nifty at 4500\

iv) Seller of Infosys July Put option of strike 1550: The seller of the Put option has the obligation to buy Infosys at 1550

It is to be noted that the right always remains with the buyer of the option while the seller of an option always has the obligation. In return, the buyer pays the seller a premium for getting the right. This premium is the maximum possible loss for the buyer and the maximum possible gain for the seller. We will discuss options in much greater details in later publications.

Swaps:

A swap is a derivative in which two counterparties agree to exchange one stream of cash flows against another stream. They are thus rightfully complex instruments. Swaps can be used to hedge interest rate risks or to speculate on changes in the underlying prices. Due to the speculative face of such derivative products, they might now be allowed in some countries with tighter regulations. So, where in if a company has a loan with a fixed interest rate , and another company has a loan with floating rate of interest , they would exchange interest rates , but only exchange the principle amount in principle , that is not actually exchange the loan amount , but settle it themselves in their own countries for each other’s vendors/suppliers effectively. Thus if an interest rate goes upward , the company who has now a fixed rate of interest will gain , and the company with floating rate of interest will pay excess interest on that loan. This situation is effectively reversed when the interest rate goes down below the determined rate of interest.