DERIVATIVES

What is a Derivative?

The word 'Derivative' originates from mathematics and refers to a variable, which has been derived from another variable. In other words it is a security which doesn’t have its own value but it derives its value from one or more underlying assets. The derivative itself is merely a contract between two or more parties and its value is determined by fluctuations in the value of the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes and further it also includes derivatives based on weather data like the amount of rainfall, etc. The main reason why derivatives are common are they can be used both as a hedging and speculative purposes.

For example, a derivative contract on Sugar depends upon the price of Sugar. And in same way, a derivative of the shares of L&T (underlying) will derive its value from the share price (value) of L&T.

Derivatives are specialised contracts which signify an agreement or an option to buy or sell the underlying asset of the derivate up to a certain time in the future at a prearranged price, the exercise price.

Let us understand the concept of Derivatives with a very basic example:

A farmer has sown wheat but he hasn’t harvested it yet. He fears that price of wheat (underlying) when harvested and ready for delivery, will be less than his production cost. Thus in order to overcome this risk, he enters into a “Contract” to sell his standing crop on some date in the future at a predetermined price.

Let’s say the production cost is 23,000 Rs per ton. Farmer is doing a contact with a merchant on 1st January to sell his standing crop on 1st March for a set price of 24,000 Rs per ton. By doing so, he can avoid the risk of fall in price of his crop in future. If selling price of wheat on 1^st march is 21,000 Rs per ton than the derivative contract is said to be more valuable for farmer because farmer can sell his wheat at 24,000 Rs per ton even though market price is much less (21,000 Rs per ton).

Participants in a Derivative Market

The derivatives market is similar to any other financial market and has following three broad categories of participants:

•  Hedgers: 

T                These are investors with a present or anticipated exposure to the underlying asset which is subject to price risks. Hedgers use the derivatives markets primarily for price risk management of assets and portfolios. The farmer mentioned in the above example can be a typical hedger.

•  Speculators: 

                     These are individuals who take a view on the future direction of the markets. They take a view whether prices would rise or fall in future and accordingly buy or sell futures and options to try and make a profit from the future price movements of the underlying asset.

•  Arbitrageurs: 

                 They take positions in financial markets to earn riskless profits. The arbitrageurs take short and long positions in the same or different contracts at the same time to create a position which can generate a riskless profit.

Derivatives

 

Derivatives can be classified into:

EXCHANGE TRADED                                                                                 

1)      Futures                                                                                   

2)      Options                                                                                     

OVER THE COUNTER

1)      Financial Swaps

2)      Forward Rate Agreements (FRA)

3)      Forward Contracts

    The knowledge of the following terms is necessary to comprehend the concept of Derivatives- :

·         Spot prices: The price of the underlying asset at the time the contract is entered.

·         Forward/ future/ options price: the price for which the contract is entered into in the present time.

·         The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party.

What are futures contracts?

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in future for a certain price. These are basically exchange traded, and are in the form of standardized contracts. The exchange stands guarantee to all transactions and hence, the counterparty risk (the risk that one of the parties to the contract may not fulfil his or her obligation) is largely eliminated. The buyers of futures contracts are considered having a long position whereas the sellers are considered to be having a short position. It should be noted that this is similar to any asset market where anybody who buys is long and the one who sells in short. (The concept of long and short position is explained below)

What are forwards Contracts?

These are generally in the form of promises to deliver an asset at a pre-determined date in future at a pre-agreed price. The contracts are traded over the counter (OTC) (i.e. outside the stock exchanges, directly between the two parties) and can be customized according to the needs of the parties. Since these contracts do not fall under the purview of rules and regulations of an exchange, they generally suffer from counterparty risk.

What are Options?

Options give the buyer (holder) a right but not an obligation to buy or sell an asset in future. Options are of two types - Calls and Puts.

Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date.

Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

One can buy and sell each of the contracts. When one buys an option he is said to be having a long position and when one sells he is said to be having a short position. It should be noted that, in the first two types of derivative contracts (forwards and futures) both the parties (buyer and seller) have an obligation; i.e. the buyer needs to pay for the asset to the seller and the seller needs to deliver the asset to the buyer on the settlement date.

 In case of Options only the seller (also called option writer) is under an obligation and not the buyer (also called option purchaser). The buyer has a right to buy (call options) or sell (put options) the asset from / to the seller of the option but he may or may not exercise this right. In case the buyer of the option does exercise his right, the seller of the option must fulfil his all obligation (for a call option the seller has to deliver the asset to the buyer of the option and for a put option the seller has to receive the asset from the buyer of the option).