Introduction to Derivatives
FINANCIAL DERIVATIVES
“I am telling you, the world’s first trillionaires are going to come from somebody who masters financial derivatives and applies it in ways we never thought of.” ~Mark Cuban
The idea of derivatives in finance can directly be traced to financial contracts that two parties undertake in order to extract some kind of monetary worth. Financial players trade financial derivatives for several reasons.
The distinguishing feature of a derivative contract is the fact that its price is derived from an underlying asset.
Suppose you and your friend love cricket. There is a match between India and Australia. You have a strong reason to believe that Virat Kohli will score a century. But your friend strongly believes otherwise. So you two make a deal. She pays 100 bucks if he scores and you pay 100 is he does not.
Therefore in the above example, the price of the contract is derived from the probability of Virat Kohli scoring a century.
You speculate that he will score while your friend speculates that he will not, however you both hope to benefit from your respective speculations. This is the underlying intuition that goes behind a derivative contract.
So clearly, in this case, we notice that this is a contract with specified terms and conditions, where both parties hope to gain something from it.
Now, there is a subject in finance called “Derivative Pricing”, which concerns itself with analyzing such contracts and determining their price and expected returns.
DEFINITION
A derivative is a contract between two or more parties whose price is derived from its underlying financial asset or set of assets.
Four most common examples of derivative instruments are Forwards, Futures, Options, and Swaps.
In this blog, we will be focusing on Forwards and Futures with a detailed explanation with important differences.
FORWARD CONTRACT
Suppose there is a farmer who produces apples on his farm, and there is a pie factory that makes apple pies. The “market price” or the price at which apples are sold in the market fluctuate during different times of the year.
If the price of apples goes up to say, INR 150 per kg, farmers are happy but the pie factory owners render losses. And similarly, if the price of apples goes down to say, INR 40 per kg, the farmers can’t even cover the cost of their produce while the pie factory makes huge profits.
Now, if both the parties (farmer and factory owner) don’t like the unpredictability of these prices, they sign an agreement to fix the price at which their transaction shall take place. Suppose, they sign a contract which puts an obligation on the farmer to sell 1 tonne apples at INR 80 per kg next year after the harvest, no matter what the market price in the future is and similarly an obligation is put on the pie factory to buy those apples from the farmer at the same price.
Now let us assume two cases:
Case 1:
If the market price of apples is Rs 60 per kg, the farmer is at a profit as he gets to sell the apples at Rs 20 per kg more than the current market price according to the derivative contract while the factory owner incurs a loss as he has to buy it at Rs 20 per kg more than the market price.
Case 2:
If the market price of apples is Rs 100 per kg, the factory owner is at a profit as he gets to buy the apples at Rs 20 per kg less than the current market price according to the derivative contract while the farmer incurs a loss as he has to sell it at Rs 20 per kg less than the market price.
This way, both buyer and producer escape (hedge) the risk associated with fluctuations in the market price of the product.
This contract is called a forward contract. This is an example of a derivative since the price of the contract is derived from the underlying asset (in this case, apples). This underlying asset need not be any commodity, it can also be currency, stocks, or even a property.
FUTURES CONTRACT
In the previous example, a question might have popped up in your mind. What if the farmer isn’t able to fulfill his promise to deliver 1-tonne apples due to bad harvest, or what if the pie factory owner goes bankrupt and isn’t able to fulfill his promise to buy apples at the settled price?
Well, this is called “counterparty risk”.
Another question that comes to one’s mind is what if the farmer isn’t able to find any suitable client who is willing to buy such huge quantities of apples?
This is called “liquidity risk”.
So now, what mechanism can we follow to protect ourselves from these risks?
Suppose there is a big firm that buys and sells such contracts (derivatives). The firm buys a contract from the farmer saying that it will buy 1-tonne apples next year after harvest at INR 75 per kg. Now, the firm breaks the contract into 10 contracts of 100 kg each with a settlement price of INR 80 per kg and sells it to 10 different pie factories.
If the farmer fails to deliver 1-tonne apples, the firm will have to bear the losses associated with this counterparty default. Similarly, if the buyers of the contract fail to buy apples at the settlement price, again the firm will bear the loss. So, both farmer and pie factories are protected from the counterparty risk. Also, the farmers now need not worry to find buyers for this contract.
Now, why would the firm take all the risk on itself? If you noticed, there was a difference in ‘buy’ and ‘sell’ price of the apples. The firm was buying apples at 75 and selling at 80 thus making 5*100 rupees profit on each contract. And this “big firm” is usually called a “clearing-house”.
Long story short, derivatives contract largely consists of 3 activities:
- Hedging: the farmer is hedging to protect himself from fluctuating prices
- Speculation: the buyers of the contract, who are actually betting on the direction of movements of prices
3. Arbitrage: market makers who advantage from the inefficiency of the markets by earning the “bid-ask” spreads
We will dig deeper into futures and forwards and be taking up options and swaps in the upcoming blogs.
This was a basic introduction to one of the biggest markets in finance known as derivatives. The notional principal of the derivatives market is nearly a zillion dollars! (1000 trillion dollars) which several multiples of the total GDP of all countries. We shall introduce more types of derivatives in the upcoming blogs.
