Introduction to Derivatives

A derivative is a financial contract that derives its value from an underlying asset. The buyer agrees to purchase the asset on a specific date at a specific price. The most common types of derivatives are forwards, futures, options, and swaps. The most common underlying assets include commodities, stocks, bonds, interest rates, and currencies. Derivatives make future cash flows more predictable. They allow companies to forecast their earnings more accurately. That predictability boosts stock prices. Businesses then need less cash on hand to cover emergencies. They can reinvest more into their business.

Derivatives are used by investors for the following:

  • To provide leverage, such that a small movement in the underlying value can cause a large difference in the value of the derivative.
  • To speculate and make a profit if the value of the underlying asset moves the way they expect.
  • To hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to the underlying position and cancels part or all of it out.
  • To obtain exposure to the underlying where it is not possible to trade in the underlying
  • To create option ability where the value of the derivative is linked to a specific condition or event

Groups of Derivative Contracts

In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in the market :

1. Over-The-Counter(OTC): OTC derivative market is the largest market for derivatives where contracts are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, exotic options and other exotic derivatives which are almost always traded in this way.

2. Exchange-Traded-Derivatives(ETD): ETD are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. It is a market where individuals trade standardized contracts that have been defined by the exchange. It acts as an intermediary to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee.

Types of Derivative Instruments/ Contracts

There are various types of contracts that are available in the market. This may make it seem like a difficult and confusing task to deal with all those derivatives. However, that is not the case. There are hundreds of variations available in the market and all of these variations can be traced back to one of the four categories :

1. Forwards: A forward contract is an agreement between two parties to buy or sell underlying assets at specified date, at agreed rate in future. Forward contract takes place between two counterparties, which means that the exchange is not an intermediary to these transactions. Hence, there is an increase chance of counterparty credit risk and the credit exposure risk keeps on increasing since profit or loss is realized only at the time of settlement.

2. Futures: A futures contract is a standardized contract, traded on exchange, to buy or sell underlying instrument at certain date in future, at specified price. Futures are standardized contracts and they are traded on the exchange. Futures contract does not carry any credit risk because the clearing house acts as counter-party to both parties in the contract. To further reduce the credit exposure, all positions are marked-to-market daily, with margins required to be maintained by all participants all the time. In derivatives market, the lot size is predefined. Therefore, one cannot buy a contract for a single share in futures. A futures contract is very similar to a forwards contract. The similarity lies in the fact that futures contracts also mandate the sale of commodity at a future data but at a price which is decided in the present. Also in case of a futures contract, they buyer and seller do not enter into an agreement with one another, rather both of them enter into an agreement with the exchange.

3. Options: Options are the most important part of derivatives contract. An Option contract gives the right but not an obligation to buy/sell the underlying assets. The buyer of the options pays the premium to buy the right from the seller, who receives the premium with an obligation to sell the underlying assets if the buyer exercises his right. Options can be traded in both OTC market and exchange traded markets. Options can be divided into two types – Call and Put. Call Option allows you the right but not the obligation to buy something at a later date at a given price whereas Put Option gives you the right but not the obligation to sell something at a later date at a given pre-decided price.

4. Swaps: A swap is a derivative contract which is not traded at exchange but made between two parties to exchange cash flows in the future. Interest rate swaps and currency swaps are the most popular swap contracts, which are traded over the counters between financial institutions. Swaps enable companies to avoid foreign exchange risks amongst other risks. These are private contracts which are negotiated between two parties. Usually investment bankers act as middlemen to these contracts. Hence, they too carry a large amount of exchange rate risks.

The use of derivatives can result in large losses because of the use of leverage. Derivatives allow investors to earn large returns from small movements in the underlying asset’s price. Conversely, investors could lose large amounts if the price of the underlying moves against them significantly.

Deepak Joshi- CA Final Student –  E-mail: deepakjoshi726@hotmail.com

 (This article is compiled by me and any correction and feedback would be greatly appreciated)

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