Derivatives
A derivative is a security or contract designed in such a way that
its price is derived from the price of an underlying asset. For instance, the
price of a gold futures contract for October maturity is derived from the price
of gold. Changes in the price of the underlying asset affect the price of the
derivative security in a predictable way.
Evolution of derivatives
In the 17th century, in Japan, the rice was been grown abundantly;
later the trade in rice grew and evolved to the stage where receipts for future
delivery were traded with a high degree of standardization. This led to forward
trading.
In 1730, the market
received official recognition from the “Tokugawa Shogunate” (the ruling clan of
shoguns or feudal lords). The Dojima rice market can thus be regarded as the
first futures market, in the sense of an organized exchange withstandardized
trading terms.
The first futures markets in the Western hemisphere were developed
in the United States in Chicago. These markets had started as spot markets and
gradually evolved into futures trading. This evolution occurred in stages. The
first stage was the starting of agreements to buy grain in the future at a
pre-determined price with the intension of actual delivery. Gradually these
contracts became transferable and over a period of time, particularly delivery
of the physical produce. Traders found that the agreements were easier to buy
and sell if they were standardized in terms of quality of grain, market lot and
place of delivery. This is how modern futures contracts first came into being.
The Chicago Board of Trade (CBOT) which opened in 1848 is, to this day the
largest futures market in the world.
Kinds of financial derivatives
1) Forwards
2) Futures
3) Options
4) Swaps
1) Forwards
A forward contract refers to an agreement between two parties, to
exchange an agreed quantity of an asset for cash at a certain date in future at
a predetermined price specified in that agreement. The promised asset may be
currency, commodity, instrument etc,
In a forward contract, a user (holder) who promises to buy the
specified asset at an agreed price at a future date is said to be in the ‘long
position’. On the other hand, the user who promises to sell at an agreed price
at a future date is said to be in ‘short position’.
2) Futures
A futures contract represents a contractual agreement to purchase
or sell a specified asset in the future for a specified price that is
determined today. The underlying asset could be foreign currency, a stock
index, a treasury bill or any commodity. The specified price is known as the
future price. Each contract also specifies the delivery month, which may be nearby
or more deferred in time.
The undertaker in a future market can have two positions in the
contract: -
a) Long position is when the buyer of a futures contract agrees to
purchase the underlying asset.
b) Short position is when the seller agrees to sell the asset.
Futures contract represents an institutionalized, standardized
form of forward contracts. They are traded on an organized exchange, which is a
physical place of trading floor where listed contract are traded face to face.
A futures trade will result in a futures contract between 2 sides-
someone going long at a negotiated price and someone going short at that same
price. Thus, if there were no transaction costs, futures trading would
represent a ‘Zero sum game’ what one side wins, which exactly match what the
other side loses.
Types of futures contracts
a) Agricultural futures
contracts:
These contracts are traded in grains, oil, livestock, forest
products, textiles and foodstuff. Several different contracts and months for
delivery are available for different grades or types of commodities in
question. The contract months depend on the seasonality and trading activity.
b) Metallurgical futures
contract:
This category includes genuine metal and petroleum contracts.
Among the metals, contracts are traded in gold, silver, platinum and copper. Of
the petroleum products, only heating oil, crude oil and gasoline is traded.
c) Interest rate futures
contract:
These contracts are traded on treasury bills, notes, bonds, and
banks certification of deposit, as well as Eurodollar.
d) Foreign exchange futures
contract:
These contracts are trade in the British Pound, the Canadian
Dollar, the Japanese Yen, the Swiss Franc and the Deutsche Mark. Contracts are
also listed on French Francs, Dutch Guilders and the Mexican Peso, but these
have met with only limited success.
3) Options
An option contract is a contract where it confers the buyer, the
right to either buy or to sell an underlying asset (stock, bond, currency, and
commodity) etc. at a predetermined price, on or before a specified date in the
future. The price so predetermined is called the ‘Strike price’ or ‘Exercise
price’.
Depending on the contract terms, an option may be exercisable on
any date during a specified period or it may be exercisable only on the final
or expiration date of the period covered by the option contract.
Option Premium
In return for the
guaranteeing the exercise of an option at its strike price, the option seller
or writer charges a premium, which the buyer usually pays upfront. Under
favorable circumstances the buyer may choose to exercise it.
Alternatively, the buyer may
be allowed to sell it. If the option expires without being exercised, the buyer
receives no compensation for the premium paid.
Writer
In an option contract, the
seller is usually referred to as “writer”, since he is said to write the
contract.
If an option can be excised
on any date during its lifetime it is called an American Option. However, if it
can be exercised only on its expiration date, it is called an European Option.
Option
instruments
Call Option
A Call Option is one, which gives the option holder the right to
“buy” an underlying asset at a pre-determined price.
Put Option
A put option is one, which gives the option holder the right to
“sell” an underlying asset at a pre-determined price on or before the specified
date in the future.
Double Option
A Double Option is one,
which gives the Option holder both the right to “buy” or “sell” underlying
asset at a pre-determined price on or before a specified date in the future.
SWAPS
A SWAP transaction is one where two or more parties exchange
(swap) one pre-determined payment for another.
There are three
main types of swaps:-
Interest Rate swap
An Interest Rate swap is an agreement between 2 parties to
exchange interest obligations or receipts in the same currency on an agreed
amount of notional principal for an agreed period of time.
Currency swap
A currency swap is an agreement between two parties to exchange
payments or receipts in one currency for payment or receipts of another.
Commodity swap
A commodity swap is an arrangement by which one party (a commodity
user/buyer) agrees to pay a fixed price for a designated quantity of a
commodity to the counter party (commodity producer/seller), who in turn pays
the first party a price based on the prevailing market price (or an accepted
index thereof) for the same quantity.
