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Derivatives Home » Knowledge Center » Derivatives

A derivative is a financial instrument whose value is derived from the price of a more basic asset called the underlying asset.

The usual textbook definition given for derivatives is something like, "instruments derived from securities or physical markets".

However the word "derivatives" has become a catch-all generic term that has been used to include all types of new (and some old) financial instruments.

The most common types of derivatives that ordinary investors in the markets are likely to come across are futures, options and warrants. Beyond this, the derivatives range is only limited by the imagination of investment banks.

It is likely that any person who has funds invested, (e.g. an insurance policy or a pension fund), are exposed to derivatives in some or other way.

Due to their great flexibility, derivatives are used by many different types of investors. Derivatives allow the modern investor the full range of investment strategy: speculation, hedging, arbitrage and all combinations thereof. When one reads about derivatives offering the sophisticated management of risk - this is not just marketing hype. They truly do offer the fund management, insurance and pension industries additional ways to achieve their investment policies.

Types of derivatives:

Forward, Futures, Options, Swap.

Forward:

Forward contracts give the owner the right and obligation, to buy or sell a given security at a specified price on (or perhaps before) a specified date.

The long position on the contract agrees to buy the security on the date. They are betting the price will go up.

The short position on the contract agrees to sell the security on the date. They are betting the price will go down.

Forward contracts can be worth less than zero. If I have the long position on an expiring forward contract for NPR100 and the price is NPR90, this will cost me NPR10.

The fact that certain options can go negative mandates margin requirements, where the owner must put money in escrow to prove they can cover the losses.

Forward contracts are used in commodity trading to hedge the risks of fluctuations.

Forward contracts are signed between two parties, not traded on exchanges.

Closely related futures contracts for commodities are traded on exchanges.

Futures differ from forward contracts in allowing more flexibility on the timing of when the short position must sell.

Relating Spot and Forward Prices

What is the correct forward price for a security/asset whose current (spot) price is ? If the forward price is too high, can be borrowed money to buy the asset, and take a short position to guarantee myself a profit.

Futures:

A futures contract is: - an agreement to buy from, or sell to, - a futures exchange, - a standard quantity and quality - of a specified asset - on a specific date, - at a price that is determined at the time of trading the contract.

In a world of volatile asset prices, futures contracts fulfill two purposes. Firstly, they allow investors to hedge the risks of adverse price movements. The standardized nature of futures contracts also lead to lower transaction and information costs. Secondly, futures markets provide speculators with a high degree of leverage, because the initial margin is relatively small in comparison with the size of the exposure given by the futures contract.

For futures contracts to fulfill these two primary purposes standardized contracts are essential. The standardization of contracts, where everything is fixed except the price, enables participants to buy and sell them freely on the exchange, where they are traded with precise knowledge regarding the characteristics of the contracts in question.

WHAT ECONOMIC JUSTIFICATION IS THERE FOR FUTURES?

From an economic point of view, the function of futures markets is to allow for the transfer of risk. Critics of futures markets argue that they are nothing more than legalized gambling dens for businessmen.

The line between gambling and investment is not always a clear one, but a line certainly can be drawn. Gambling refers to a situation which is contrived precisely so that someone may wager for personal gain. Investment, on the other hand, is generally regarded as the commitment of money (or other assets) to an enterprise or activity which has intrinsic economic value and offers a reasonably high probability of growth. A good example is a share, which is part ownership of an enterprise which in its turn will offer employment, produce goods, pay rent, etc. It is true that a speculator can in fact buy the company's shares in the secondary market and "speculate" on whether they go up or down, but this is not the reason that the shares existed in the first place.

Mechanism for the transfer of risks is generally accepted as essential for the smooth functioning of modern society. Insurance is the most common form of risk transfer: a policy holder insures himself against the risk of theft, loss of earnings, accidents, legal action, and a host of other risks, simply by paying an amount of money each month to an insurer.

Share markets are also a mechanism for transferring risk. An efficient secondary market allows investors to liquidate their holdings in shares if they are no longer prepared to bear the risks of share ownership. Without the share market, the investor in an enterprise would be in much the same position as a partner in a small firm or shareholder in a proprietary limited company: selling his interest would be difficult because of the problem of locating a buyer and the problem of establishing price.

Futures markets serve a vital function within the area of risk transfer. They have the special function of allowing those who do not wish to take risks to nevertheless run business enterprises. A farmer who has acquired considerable skills in agriculture but is totally put off by the prospect of volatile prices in the grain market can use futures to allow him to exercise his skills - growing corn - without having to bear all the risks of severe price fluctuations on top of the normal crop risks which he bears anyway. In short, the futures markets enable many productive entrepreneurs and businessman to operate without exposing themselves to risks greater than they are willing to bear.

The futures markets are also valuable to the economy in that they facilitate "price discovery" and the rapid dissemination of prices.

In a traditional forward market, contracts are not standardized and are entered into directly between buyers and sellers. The prices at which forward contracts are fixed are not relayed to the market because they are "private" deals. Price determination in the overall market is therefore not as efficient as it could be, and buyers and sellers cannot be sure that they are getting the best possible price. In the futures markets, by contrast, the competitive nature of the traders ensures that commodities trade at or very close to what the market thinks they are worth, and the smallest market user has as much knowledge as the largest user as to the current value attached to the commodity.

CALCULATION THE FAIR VALUE OF A FUTURES CONTRACT

The theoretical price of a futures contract can be divided into three main elements:

  • The spot price of the underlying asset;
  • The financing cost, such as interest, storage or insurance costs for the underlying cash market asset;
  • The cash flow, if any, generated by the underlying asset.

Futures price = cash price + fc - cf
Where fc = financing cost (or gross carry cost)
cf = cash flow of underlying asset (if applicable)


The above formula is at times also written as:
Futures price = cash price + net carry cost
where net carry cost = fc - cf


The net carry cost can be positive or negative depending on the relative size of the financing cost and the cash flow of the underlying asset.
Storable futures are calculated using the carry-cost pricing model, while perishable futures are priced by means of the implied-forward rate pricing model.

Options:

An option to buy is known as a call option, and is usually purchased in the expectation of a rising price; an option to sell is called a put option and is bought in the expectation of a falling price or to protect a profit on an investment. Options, like futures, allow individuals and firms to hedge against the risk of wide fluctuations in prices; they also allow speculators to speculate for large profits with limited liability. It costs nothing upfront to enter into a futures contract, whereas there is an immediate cost of entering into an options contract.

Swaps:

Brief Introduction on Swaps

Definition:

  • A derivative, where two counterparties exchange one stream of cash flows against another stream (legs of swap)
  • Calculated over a notional principal amount
  • to hedge certain risks (e.g. interest rate risks)

Equity swaps are exchanges of cash flows in which at least one of the indices is an equity index. An equity index is a measure of the performance of an individual stock or a basket of stocks.

Commodity Swaps: : Producers need to manage their exposure to fluctuations in the prices for their commodities. They are primarily concerned with fixing prices on contracts to sell their produce. A gold producer wants to hedge his losses attributable to a fall in the price of gold for his current gold inventory. A cattle farmer wants to hedge his exposure to changes in the price of his livestock.

End-users need to hedge the prices at which they can purchase these commodities. A university might want to lock in the price at which it purchases electricity to supply its air conditioning units for the upcoming summer months. An airline wants to lock in the price of the jet fuel it needs to purchase in order to satisfy the peak in seasonal demand for travel.

Speculators are funds or individual investors who can either buy or sell commodities by participating in the global commodities market. While many may argue that their involvement is fundamentally destabilizing, it is the liquidity they provide in normal markets that facilitates the business of the producer and of the end-user.

Why would speculators look at the commodities markets? Traditionally, they may have wanted a hedge against inflation. If the general price level is going up, it is probably attributable to increases in input prices. Or, speculators may see tremendous opportunity in commodity markets. Some analysts argue that commodity markets are more technically-driven or more likely to show a persistent trend.

The futures markets have been the traditional vehicles for participating in the commodities markets. Indeed, derivatives markets started in the commodities field.

Types of commodity swaps

There are two types of commodity swaps: fixed-floating or commodity-for-interest.

Fixed-floating swaps are just like the fixed-floating swaps in the interest rate swap market with the exception that both indices are commodity based indices.

General market indices in the commodities market with which many people would be familiar include the Goldman Sachs Commodities Index (GSCI) and the Commodities Research Board Index (CRB). These two indices place different weights on the various commodities so they will be used according to the swap agent's requirements.

Commodity-for-interest swaps are similar to the equity swap in which a total return on the commodity in question is exchanged for some money market rate (plus or minus a spread).

Valuing commodity swaps

In pricing commodity swaps, we can think of the swap as a strip of forwards each priced at inception with zero market value (in a present value sense). Thinking of a swap as a strip of at-the-money forwards is also a useful intuitive way of interpreting interest rate swaps or equity swaps.

Commodity swaps are characterized by some idiosyncratic peculiarities, though.

These include the following factors for which we must account (at a minimum):

  • The cost of hedging
  • The institutional structure of the particular commodity market in question
  • The liquidity of the underlying commodity market
  • Seasonality and its effects on the underlying commodity market
  • The variability of the futures bid/offer spread
  • Brokerage fees
  • Credit risk, capital costs and administrative costs

Some of these factors must be extended to the pricing and hedging of interest rate swaps, currency swaps and equity swaps as well. The idiosyncratic nature of the commodity markets refers more to the often limited number of participants in these markets (naturally begging questions of liquidity and market information), the unique factors driving these markets, the inter-relations with cognate markets and the individual participants in these markets.

 
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