Explaining Derivative Contracts

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Derivatives are financial instruments whose value is a function of the price of another asset, as the name implies derivative contracts derive their value from the performance of an underlying security. A derivative contract, in their most basic form, represents the right to buy or sell a security at a specified price; derivatives are generally used as a hedging tool to guard against market fluctuations. The features of derivative contracts, such as purchase or sale price, size and expiry date are all pre-determined. The value of these financial instruments is derived from an underlying asset (stocks, bonds, commodities etc). Traders can swap interest rates, take bets on whether a firm can go bankrupt and safeguard against future asset price increases.

Two common types of Derivatives are:

Futures:  A future contract is an agreement to buy or sell an underlying asset in the future at a pre-determined price. The buyer in this transaction is obliged to take delivery of a specific quantity of an underlying asset at a specific date and price determined at the time of transaction. Conversely, the seller agrees to deliver a specific quantity of an underlying asset at a specific date and price determined at the time of transaction.

For example: When an investor gets into a futures contract, he agrees to buy or sell an asset at a predetermined price in the future. For example today is 18th July and the spot price of gold is $1,000, a three month gold future (expiring on 18th October) is trading at $ 1,010. As an investor I believe the price of gold is going to rise over the next three months, so i enter into a long futures contract at current future prices of $ 1,010. As on 18th October, the gold spot price would increase to $ 1,100, so I make a profit of $ 90. Similarly if gold prices had fallen to below $1,010 as on 18th October, i would have incurred a loss equal to the difference between the initial futures price and the final spot price.

Options: An option contract is an agreement between two parties for a specified time period which gives the holder the right, but not the obligation, to buy or sell a specified number of shares, at a pre-determined price. Options can be bought and sold like shares.

There are two types of options:

Call: A call option gives its holder the right, but not the obligation, to purchase a specific quantity of an underlying asset, at a given price for a specified time period. In order to obtain that right, the holder must pay a premium to the seller. The seller of the call option has the obligation to sell a specific quantity of an underlying asset at the strike price indicated, if the holder exercises his right. Against this obligation, the writer receives a premium paid by the buyer.

For Example: Today is 18th July and as quoted in the earlier example, the spot price of gold is $ 1,000, a call option that gives the holder the right to purchase gold for $ 1,000 as on 18th October is trading at $ 30. As an investor I believe the price of gold is going to rise over the next three months, so i spend $ 30 to and purchase the call option. As on 18th October, the price of gold is $ 1,100, now i exercise the “call” option and purchase gold for $ 1,000 and make a profit of $ 100. My net profit after deducting the cost of option would be $ 70. If the market price at expiry was below $ 1,000, i would not have exercised this option (as the market price is cheaper than the option strike price) and my profit would have been zero, after factoring the cost of option my net loss would be $ 30. The major advantage of this form of derivate trading (as quoted in the example) is if the prices of gold were to fall, no matter how much it fell, my maximum loss would always be at $ 30, the price paid for the option, whereas my net profit from is infinite.

Put: A put option gives its holder the right, but not the obligation, to sell a specific quantity of an underlying asset, at a given price (strike price) by a specific date (the expiration date). In order to obtain this right, the holder must pay a premium to the buyer. The buyer has the obligation to purchase a specific quantity of the underlying asset at the strike price indicated, if the holder exercises his right. Against this obligation, the writer receives the premium paid by the buyer.

For Example: You bought a company’s shares for $ 31, but you are concerned the shares of the company may drop due to a weakening market. A good way to protect yourself from this situation is to buy a ‘put’ option. So you decide to buy an August 30th put for a premium of $ 1, which costs you $ 100. Buy buying the put you are locking the value of your stock at $ 30 per share until the expiration date. If the stock price falls to $ 20 per share, you can still sell it someone at $ 30 per share, as long as the option has not expired. By using this option as portfolio insurance, it fixes your worst risk at $ 200, which is inclusive of the $ 100 premium and the loss of $ 1 per share you can lose after paying $ 31 per share for the stock.

Forward Contract: A forward contract is an agreement to sell a currency, commodity or other asset at a specified future date and at a predetermined price. This may be the current price or the exchange price, or an agreed forward price, which would be at a discount or premium to the spot rate. Fundamentally, forward and future contracts have the same function as both contracts allow the traders to buy to buy or sell a specific asset at a specified time and a given price, however, future contracts are exchange traded and hence standardized contracts. Forward contracts on the other hand are private agreements between two parties and are not rigid to the terms and conditions stated in the agreement. The chance of default in this contract is high due to the absence of an exchange or clearing houses. Future contracts have clearing houses that guarantee the transactions and lowering the probability of default drastically.

Swaps: Swaps are derivative contracts and trade over the counter. The most commonly traded and liquid interest rate swaps are known as “vanilla” swaps, which exchange fixed rate payments for floating rate payments based on LIBOR and FCA regulations. Swaps have been categorised into equity swaps, commodity swaps, currency swaps and interest swaps.

Who Bears the Risks ?

After reading the above paragraphs of the article, you may be puzzled to understand who will ultimately bear the risk of derivatives? And what is the purpose of investors and speculators in the derivative market? Assad Dossani, a financial analyst and columnist who also trades on derivatives says, Investors take on the risks that hedgers want to get rid of, hedgers pass on the risk to investors and investors as a result expect to earn a profit for taking on the risk. 

http://www.internationalfinancemagazine.com/article/Explaining-Derivative-Contracts.html

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