Derivatives

• Derivatives

  Financial instrument/contracts whose price/value is dependent on the price of another asset, known as the 'underlying'
• Examples of underlying assets

  • Financial assets (bonds and shares)
  • Commodities (oil, gold, silver, corn, wheat)
  • Currencies
  • Indices
  • Other reference assets (weather)
• The underlying assets' value fluctuates in response to market conditions
• Main idea behind getting into derivative contracts

  To benefit by betting on the future value of the underlying asset
• Over-the-counter (OTC) trading


  Trading that takes place directly between counterparties
• Exchange-traded derivatives


  Derivatives that are traded on an exchange, such as the Chicago Mercantile Exchange (CME)
• Uses of derivatives

  • Hedging
  • Anticipating future cash flows
  • Asset allocation changes
  • Arbitrage
  • Speculation
• Hedging

  A technique employed by portfolio managers to reduce portfolio risk, such as the impact of adverse price movements on a portfolio's value
• Anticipating future cash flows

  If a portfolio manager expects to receive a large inflow of cash to be invested in a particular asset, then futures can be used to fix the price at which it will be bought and offset the risk that prices will have risen by the time the cash flow is received
• Asset allocation changes

  Changes to the asset allocation of a fund, whether to take advantage of anticipated short-term directional market movements or to implement a change in strategy, can be made more swiftly and less expensively using derivatives such as futures than by actually buying and selling securities within the underlying portfolio
• Arbitrage


  The process of deriving a risk-free profit from simultaneously buying and selling the same asset in two different markets, when a price difference between the two exists
• Speculation

  Involves assuming additional risk (betting) in an effort to make, or increase, profits in the portfolio
• Types of derivatives

  • Exchange Traded (Futures, Options)
  • OTC (Forwards, Swaps)

  
• Forwards

  Holder is charged to perform the contract, not traded on stock exchanges, available over-the-counter (OTC) and not market-to-market, can be customized as per the requirements of the parties involved
• Futures

  Standardized contracts that allow the holder to buy and/ or sell the asset at an agreed price at the specified date, the parties are under an obligation to perform the contract, can be traded on the stock exchange, the value of such future contracts is marked to the market every day
• Options

  Contracts that give the buyer a right to buy and/ or sell the underlying asset at the specified price during a particular period of time, the buyer is not under any obligation to perform the option, the seller is known as the 'option writer' and the specified price is called the strike price
• Swaps

  Two parties exchange their financial obligations under this contract, cash flows are based on a principal amount agreed by both the parties without exchanging the principal, the amount is based on a rate of interest, while one cash flow remains fixed, the other changes based on the benchmark rate of interest, swaps are OTC contracts between businesses and/ or financial institutions and are not traded on stock exchanges
• Derivatives provide a mechanism by which the price of assets or commodities can be traded in the future at a price agreed today, without the full value of this transaction being exchanged or settled at the outset
• Futures contract

  A legally binding agreement between a buyer and a seller, the buyer agrees to pay a pre-specified amount for the delivery of a particular pre-specified quantity of an asset at a pre-specified future date, the seller agrees to deliver the asset at the future date, in exchange for the pre-specified amount of money
• Futures contract

  • It is exchange-traded, it is dealt on standardised terms (the exchange specifies the quality of the underlying asset, the quantity underlying each contract, the future date and the delivery location, only the price is open to negotiation)
• Futures terminology

  • Long (buyer's position)
  • Short (seller's position)
  • Open (initial trade entry)
  • Close (exiting a futures position before the delivery date)
  • Covered (seller possesses the underlying asset)
  • Naked (seller lacks the underlying asset)

  
• Options flourished post-1973 with the pricing model by Fisher Black and Myron Scholes

  1973
• Chicago Board Options Exchange (CBOE) established

  1973
• Standardized options contracts became prevalent
• Expansion of options exchanges, including LIFFE (now part of ICE), ensued
• Option

  Provides the buyer the right (but not the obligation) to buy or sell a specified quantity of an underlying asset at a predetermined exercise price, on or before a specified future date or between two given dates, the seller, in exchange for a premium, grants this option to the buyer
• Options traded on exchanges follow standardized sizes and terms, occasionally, investors may desire non-standard options, trading them over-the-counter (OTC), where contract specifications are customized by the parties involved
• Options terminology


  • Strike Price
  • Call Option
  • Put Option
  • Holders
  • Writers
  • Expiration Date
  • European Option
  • American Option
  • Options Premium
  • Contract Value
  • Buyer Of A Call/Put Option
  • Writer (Or Seller) Of A Call / Put Option
  • Option Price
  • In-The-Money Option
  • Out-Of-The-Money Option
  • At-The-Money Option

  
• Writer (Or Seller) Of A Call / Put Option


  The Writer of a Call/Put Option is one who agree to sell/buy the underlying asset if the buyer of option desires so, against the receipt of option premium
• Option Price


  • Intrinsic Value + Time value
  • Intrinsic Value is difference between Strike Price and Current Market Price
  • Time value premium decreases as the option approaches maturity
• In-The-Money Option


  An option is said to be In-the-money at a given time, if on exercising the option at that time, it would bring cash inflow for the buyer. This happens when the strike price of the underlying asset is less than its spot price
• Out-Of-The-Money Option


  An option is said to be Out-of-the-money at a given time, if on exercising the option at that time, it would result in cash outflow for the buyer. This happens when the strike price of the underlying asset is greater than its spot price
• At-The-Money Option


  An option is said to be At-the-money at a given time, if on exercising the option at that time, it would be cash neutral for the buyer. This happens when the strike price of the underlying asset is equal to its spot price. But a movement in either direction leads it to becoming in-the-money or out-of-the-money option

  
• Interest Rate Swaps


  • An agreement between two parties to exchange interest rate cash flows
  • One leg of the swap typically involves paying a fixed rate of interest, while the other leg involves paying a floating rate
  • The purpose is to manage exposure to interest rate fluctuations
  • These swaps are negotiated over-the-counter (OTC), allowing for customization to meet specific needs
• Interest Rate Risk


  STIR (Short term interest) rate futures and IRF (Interest Rate Forwards) can be used to manage interest rate risk
• Credit Default Swaps (CDSs)


  • Credit derivatives derive value from specified credit events involving a third-party company
  • They are utilized by institutions to manage credit risk exposure effectively
  • Credit derivatives enable organizations to transfer unwanted credit exposure or enhance credit exposure for income generation
  • CDS operates similar to insurance, offering protection against borrower default or instrument creditworthiness
• While beneficial for risk management, credit derivatives entail risks and have prompted regulatory measures for increased transparency and oversight
• Derivatives Exchanges


  • Derivatives exchanges operate alongside physical commodity trading, offering a mechanism for price fixation to hedge market price risk
  • The physical market involves the procurement, transportation, and consumption of real commodities globally, led by major international trading houses, governments, producers, and consumers
  • Derivatives markets serve as a vital tool for stakeholders in physical markets to hedge against price fluctuations
  • Commodity markets have evolved to include commodities as an investment asset class, attracting investors seeking diversification and potential returns
  • This expansion has led to a highly developed aspect of commodity markets, with commodities serving as standalone investment vehicles
• Derivative Exchanges all over the world

  • CME Group (US)
  • ICE (US, Canada, Europe, Singapore)
  • London Metal Exchange (LME)
  • Eurex (Germany)
• Commodity Market


  • A marketplace where people can buy, sell, and trade raw materials and primary products
  • It's a marketplace for investors to trade commodities like precious metals, crude oil, and natural gas