Basics of Derivatives

Introduction to the basic concept of derivatives

Derivatives in general refer to contracts that derive from another - whose value depends on another contract or asset. Derivatives are essentially devised as a hedging device to insulate a business from risks over which a business has no or little control, but in practice, they are also used as yield-kickers.

Where there are risks, there are derivatives to strip the risk and transfer it. As derivatives are essentially devices of transferring risks, their types and applications differ based on the type of risk facing a business. Take, for instance, the following sources of risk and the derivatives to protect a business against such risks:

Interest rate risk:

Banks and financial institutions face the risk of changes in interest rates. If a bank has liabilities carrying floating costs and assets having fixed rates, it faces the risk of an adverse movement, that is, a decline in interest rates. This risk can be sheltered by writing an interest rate swap - that is, swapping the floating rate for fixed rates.

Associated with interest rate movements is the basis risk, that is risk of unpredicted changes in the basis on which interest rates float. Let us say, a business has loans which are floating with reference to the LIBOR or EURIBOR, whereas the assets of the business are floating with reference to US treasuries. To cushion against this risk, the business may like to swap the basis by entering into a basis swap.

Foreign exchange risk:

If a business has assets or liabilities denominated in foreign currency, there is a risk of adverse changes in exchange rates. This risk is sheltered by foreign exchange futures or forward covers.

Commodity risks:

A business having any position on commodities faces risk of changes in commodity prices. Such risks are also sheltered by futures and forwards in commodities.

Risk on capital market instruments:

If someone holds equity shares, there is a risk that prices of equity shares will move up or down. To manage this risk, there are various futures and options available.

Credit risk:

Yet another risk in all financial transactions is credit risk. Credit derivatives are used to hedge against credit risk.

Weather risk:

Even something like risk of changes in weather is hedged and transferred. There is a variety of weather derivatives, that is, instruments that pay off based on weather changes.

Definition of a derivative:

Accounting standard SFAS 133 defines a derivative thus:

Types of derivatives:

The following are the basic types of derivatives:

Forwards:

A forward is a contract to buy a thing or security at a prefixed future date. The typical usage of a forward would be something like this: a business having its assets in a local currency has taken a loan repayable in a foreign currency 6 months hence. There is an exchange rate risk here: if the local currency suffers against the foreign currency, the business has to write a loss. To cover against this risk, the business enters into a forward contract - that is, it agrees today to buy the foreign currency 6 months hence at prices prevailing today, against a pre-fixed premium. Obviously, if the perceptions of the seller and the buyer as to future prices of the foreign currency differ, both will strike what they perceive is a win-win deal.

Forwards are also quite common in commodities, and can be used either for speculation or for hedging. Say, XYZ has an order to ship 10000 tons of steel 6 months hence at a prefixed price of say USD 1000 per ton (by the way, I have no idea of steel prices, this is just an example!). And XYZ expects the price of steel to go up. So, to hedge against the price risk, XYZ enters into a forward purchase agreement, for 10000 tons 6 months hence. XYZ's position is now fully hedged: if the price of steel goes up as expected, XYZ will either claim a delivery from the forward seller, or a net settlement. If the price comes down, XYZ will be obliged to settle by making a payment for the price difference to the forward seller, but will be fully offset by the pre-fixed price it gets from its own forward sale contract.

Futures:

Futures are more standardised forms of forward contracts and mostly operate in organised markets. While it is possible to have a forward contract for any commercial transaction, futures are normally exchange-traded. Futures contracts are highly uniform contracts that specify the quantity and quality of the good that can be delivered, the delivery date(s), the method for closing the contract, and the permissible minimum and maximum price fluctuations permitted in a trading day.

Distinction between forwards and futures:

The basic nature of a forward and future, in a strict legal sense, is the same, with the difference that futures are market-driven organised transactions. As they are exchange-traded, the counterparty in a futures transaction is the exchange. On the other hand, a forward is mostly an over-the-counter transaction and the counterparty is the contracting party. To maintain the stability of organised markets, market-based futures transactions are subject to margin requirements, not applicable to OTC forwards. Futures market are normally marked to market on a settlement day, which could even be daily, whereas forward contracts are settled only at the end of the contract. So the element of credit risk is far higher in case of forward contracts.

Options:

The significant difference between a future and an option is that the option provides the contracting parties only an option, not an obligation, to buy or sell a financial instrument or security at a pre-fixed price, called the strike price. Obviously, the option buyer will exercise the option only when he is in the money, that is, he gains by exercising the option.

For example, suppose X holding a security of USD 1000 buys an option to put the security at its current price with Y. Now if the price of the security goes down to USD 900. X may exercise the option of selling the security to Y at the agreed price of USD 1000 and protect against the loss on account of decline in the market value. If, on the other hand, the price of the security goes upto USD 1100, X is out of the money and does not gain by exercising the option to sell the security at a price of USD 1000 as agreed. Hence, X will not exercise the option. In other words, the option buyer can only get paid and does not stand to a position of loss.

Had this been a futures contract or forward contract, Y could have compelled X to sell the security for the agreed price of USD 1000 in either case. That is to say, while a future contract can result into both a loss and a profit, an option can only result into a profit, and not a loss.

Two basic types of options are: call options and put options. A call option is an option to call, that is, acquire a particular quantity and/or at particular strike price. A put option is just the reverse- the option to put or sell a particular quantity and/or at a particular strike price.

Swaps:

In a swap, both the parties exchange recurring payments with the idea of exchanging one stream of payments for another. A typical usage is a swap of fixed interest rates with floating rates, or rates floating with reference to one basis to another basis. In credit derivatives market, there are swaps based on the total return from a particular credit asset against total return on a reference asset.

Caps, floor and collars

Caps, floors and collars are essentially options designed to shift the risk of an upward and/or downward movement in variables such as interest rates. These are normally linked to a notional amount and a reference rate.

For example, if some one wants to transfer the risk of interest rates going up, one will enter into a cap on a notional amount of say, USD 100 million, with the interest rate of 5.5%. Now if the interest rate increases to 6%, the cap holder will be able to claim a settlement from the cap seller, for the differential rate of 0.5% on the notional amount. If the interest does not go up, or rather declines, the option holder would have paid the premium, and there is no settlement.

On the other hand, if some one expects the interest rate to go down which spells a risk to him, he would enter into a floor, which would allow him to claim a settlement if the interest rate falls below a particular strike rate.

Interest rate collar is the fixation of both a cap and floor, so that the payment will be triggered if the rate goes above the collar and below the floor.

Swaption:

A swaption is an option on a swap. The option provides the holder with the right to enter into a swap at a specified future date at specified terms. This derivative has characteristics of an option and a swap.

Symmetric and asymmetric returns:

A return from a contract or investment is said to be symmetric when it can either give a profit or incur a loss.

Returns from forwards and futures are symmetrical: if you enter into a forward at a particular price, the price might either go up or come down, and so, you might either make a profit or a loss.

However, options have an asymmetric return profile: an option is an option with one party. The option will be exercised only when the purchaser of the option is in-the-money. Therefore, the only loss in an option is the cost of writing and carrying the option. Hence, options have an asymmetric return profile.

On the other hand, the option-seller only makes returns by way of fees or premium for selling the option, against which he takes the risk of being out-of-money. If the option is not exercised, he makes his fees, but if the option is exercised, he might lose substantially.