Derivative instruments, or just derivatives as they are most popularly known, are nothing but an umbrella term for instruments like futures contracts, options, swaps, forwards contracts, and credit derivatives.
Learning about derivatives is one of the most important lessons to learn, for anyone making new forays into investment finance. If you wish to play the stock markets, they offer an unbelievable amount of ground to play in, especially when it comes to hedging and risk management. But before you start thinking about having bigger yields out of these instruments, know a little more about them. Know their uses and advantages, their drawbacks as well as their various types, namely forwards, swaps, futures and options.
What is the Derivatives Market?
They are simple financial instruments. The only difference between them and the normal financial instruments (like shares), is just the little term called ‘underlying asset’. While most financial assets have intrinsic asset values or prices, the intrinsic value of a derivative is based on the financial asset that forms the basis of a derivatives contract. By definition, they are financial instruments that derive their intrinsic values from the underlying asset that they are based on. Here’s and example of an underlying asset.
Shares of company XYZ have an intrinsic value of $20 each. These are normal financial instruments where you just buy or sell shares of company XYZ (for $20 each, if market value equals the intrinsic value). But when you have a derivative option on the shares of this company, you are basically holding a financial instrument that has no intrinsic value of its own. The value of your option to either buy or sell the shares of this company, derives its value from the actual market prices of the underlying asset, in this case, the shares of company XYZ. So for once, a financial instrument has been named correctly, an instrument that derives its value from some other asset is termed as a derivative.
These markets happen to be of two types. First the futures and options are traded on the exchange traded derivatives market and are standardized instruments with negligible credit risk. On the other hand, forwards, swaps, and CDS are usually traded on the over-the-counter (OTC) markets. These non-standardized financial instruments bear some amount of credit risk, since no exchange interferes between the buyer and the seller. Options are not limited to the exchange traded derivatives markets and some are also traded on the OTC markets.
Uses in Investment Finance
Below are some of the uses as listed by John C. Hull in his 1999 book titled ‘Options, Futures, and Other Derivatives’.
- They are very good risk management tools and are mainly used to hedge risks that a trader is routinely exposed to. They offer the trader, the option of passing on some of the risk that he’s bearing over to another party. He either takes on another risk in return or makes a cash payment in exchange for the risk transfer.
- Instruments like forwards and futures play a key role in giving directions to the market prices of the future. Forwards and futures prices are good reflectors of the price directions as well as the expected change in the future prices of the underlying asset.
- They offer the traders an option to change the nature of their liabilities and exchange the risks associated with some of their unwanted liabilities with some more bearable ones.
- They can be used to make arbitrage profits. Arbitrage profit opportunities are those opportunities that allow for risk-free, zero net investment profits, by capitalizing on price differentials on the same commodity in different markets. The intention is to buy low and sell high in two different markets and pocket the differential profits.
- They allow for large portfolio position changes without incurring the buying and selling transaction costs.
Forwards Contracts and Futures Contracts
By definition, a forwards contract is ‘an agreement to buy or sell an asset for a predetermined, fixed price, at a certain time or date in the future’. The only difference between a normal spot transaction and a forward transaction is the time span between the contract and its fulfillment. While spot is an immediate, present tense contract, a forward is a later date or future tense contract that is just being finalized today. Forwards contracts are over-the-counter contracts that usually trade on commodities.
There is no monetary transaction to the contract when it is first negotiated, and money only changes hands on contract maturity. When you hold a long position in a forward contract, i.e., you have agreed to buy the underlying commodity at the agreed price, your payoff will be the differential between the forward price and the spot rate at that point in the future (F – S). On the other hand, with a short position (agreement to sell), your payoff will be the differential between the spot price of the commodity then and the futures price that you have agreed on (S – F).
Futures contracts are derivatives very similar to forward contracts, with the main difference being that while forwards are traded OTC, futures are traded on an exchange. Futures are also agreements to buy or sell commodities at a certain predetermined price at some predetermined time in the future. The term futures encompasses all things like foreign exchange futures and stock index futures as well. Being traded on exchanges robs the futures of the customization that is available on forwards, but on the other hand, as exchanges play clearing houses in the transaction, futures have relatively lower credit risk.
Options are basically of two types, a call option and a put option. A call option gives the buyer the right but not the obligation to buy a certain asset from the call option writer, by a certain date and for a certain price, known as the strike price. Since it is the ‘right but not the obligation’ to buy an asset, it is obvious that the call option will only be exercised if the strike price is lower than the going market price for the underlying asset at that certain time in the future.
On the other hand, a put option gives the buyer the right but not the obligation to sell a certain asset at an agreed price (strike price) by a certain date in the future. In a put option, the option will thus, only be exercised if the strike price is higher than the going market price at that specific point of time in the future. Inexperienced options expire once their time duration ends and it is only the premium paid for buying the option that exchanges hands between the two parties.
A point to note here is that, while futures and forwards are obligatory buy and sell contracts for the holders, options are rights and not obligations that the holder can choose on whether to exercise or not. Options are fantastic in their ability to cater to every possible need of the stock market trader. They can be used to hedge open positions in stocks and this makes stock trading safer.
Two or more options can be combined together (synthetic options) to give the trader just the kind of payoff he was visualizing, given his forecasts of the future price movements on the stock exchange. Last but not the least, they lend monetary power to the traders, for they can take large positions in the stock market with the minimal amount of cash, i.e., by just paying the premium amounts.
Interest Rate Swaps
Interest rate swaps are also derivatives for they too derive their values from the underlying debt instrument. Plain vanilla swaps, or the least complicated of swaps, allow two parties to swap their interest obligations. For example, if a party has a fixed rate payment obligation and another one has a floating rate one, the two can swap their interest obligations with each other without settling the underlying debt.
Understanding Futures and Options
Mastering these instruments can make you a millionaire overnight, but it is good to understand them first. Research them and you will find a very grim picture, more houses have been broken with these instruments than have been built. Lack of knowledge coupled with greed, turn them into your worst possible nightmare. They are a boon for the hedgers but not always so for the arbitrageurs and speculators.
- Certain exotic types like Cacall, Caput, Barrier options, etc., lure investors with the greed of returns, but what happens many a time is that, traders fail to see the complexity involved in them. Not understanding how they work and investing large sums of money in them blindly is a folly. For many of these instruments, small changes in the underlying asset can swing your fortunes from millionaire to bankrupt within seconds. Be careful and ask all the right questions before you bring out the cash.
- Since most of them involve the play of big money with very little in the way of initial investment, most people fail to foresee the impact they can have on their total funds. Even though you have invested only $100, the position that you had taken in the market was on $10000 shares. Marginal swings in the value of these shares can leave you with the outcome – ‘Investment – $100 and Total Loss $100, 000’. For many, what they invest in these instruments are their savings so you can only imagine the impact.
- Many investors fail to understand that investing in them means indulging in a kind of leveraging. How else is it possible that just investing $10 should help you take positions worth $1000. Think about it and you’ll know why so many have gone down while betting on these instruments. You’ll know then, why all traders haven’t mastered the art yet and become overnight millionaires. When investing in these instruments, be aware of the risk that you are taking on with that kind of leverage.
- When they are used for hedging, they perform exceptionally well but when used for speculation, it is not prudent to rely too heavily on them. These are extremely powerful instruments and though, ‘no guts no glory’ does summarize the ‘higher risk, higher potential return’ mantra of investment finance; having open positions in them is never prudent. Many an investor have fallen to greed in this market, for everyone else, it is a risk management boon.
Whether futures and options, or swaps and forwards, all require careful and deliberate study. Futures and options trading is fantastic as a risk reducing measure (hedging), but may not be equally fantastic as a speculative bet, especially when you do not have the required expertise, neither in derivatives nor in forecasting.