Understanding Traditional Derivatives
Diatomix Basics
Equity markets allow companies to raise capital by selling shares of their business to investors. These markets are essential for economic growth as they allow companies to invest in new projects and hire more employees. Trading in these markets is risky, but necessary. Derivatives markets, on the other hand, play an equally important role by providing a way to manage and reduce risk, helping to protect the newly allocated capital and providing stability.
Derivatives
Derivatives are financial contracts that derive their value from an underlying asset. These could be stocks, indices, commodities, currencies, exchange rates, or the rate of interest. Financial instruments allow for the opportunity to generate profits through predicting the future value of a specific underlying asset.
Participants in the Derivatives market
The participants in the derivatives market can be broadly categorized into the following four groups:
Hedgers
Hedging is when a person invests in financial markets to reduce the risk of price volatility in exchange markets, i.e., eliminate the risk of future price movements. Derivatives are widely used in risk management due to their effectiveness in mitigating potential losses related to the underlying assets.
Speculators
Speculation is the most common market activity that participants of a financial market take part in. Speculative investing is a high-risk endeavor where an investor acquires a financial instrument or asset with the expectation that its value will significantly increase (or decrease, if the speculator has a short position) in the future.
Arbitrageurs
Arbitrage is a very common profit-making activity in financial markets that comes into effect by taking advantage of price discrepancies in financial instruments such as bonds, stocks, derivatives, etc., with the goal of making a profit.
Margin traders
In the finance industry, margin is the collateral deposited by an investor investing in a financial instrument to the counterparty to cover the credit risk associated with the investment.
Leverage
Leverage is an important concept in trading. Leveraged trading is a way for investors to magnify their market exposure with less capital. This approach, however, increases both potential profits and losses. In other words, leverage provides a way for investors to achieve more with their capital.
Leverage can be seen as a ratio DEBT(or, size of a portfolio):CAPITAL (e.g. 25:1, which means that for $1 of capital, you “control” $25). As such, it is easy to see how to “manipulate” leverage. To increase leverage, increase debt and/or decrease capital. To decrease leverage (i.e. “deleverage”), decrease debt and/or increase capital.
Example
Assuming the price of a barrel of crude oil is $70, then buying one contract of crude oil futures allows you to control: 1000 * 70 = $70,000 on this market.
Margins
As we saw, trading derivatives allows to gain exposure to the notional value of the contracts, with limited capital outlay. This initial capital — required to enter in a derivatives trade — is called the initial margin.
Initial Margin (IM)
To trade on margin (i.e. to do leveraged trading), one must first deposit an “Initial Margin”. The IM is the amount of collateral/capital to deposit in an account called the margin account to “control a derivative contract” (e.g. for a 30% initial margin requirement, you must put £300 as collateral/initial margin in your margin account to be able to open a position of £1,000).
Maintenance Margin
Once the position opened, the margin trader is highly exposed to the market and the balance of the margin account fluctuates according to the changes in the contract price (which is derived from the price of the underlying). Gains are magnified, but losses are exacerbated. So, in order to keep the system solvent and limit counterparty risk (i.e. limit “default risk” here), the traders are required to keep the amount of their margin accounts above a certain threshold: the maintenance margin requirement.
Futures Contracts
A futures contract is an agreement to buy or sell an asset, such as a commodity or financial instrument, at a pre-determined price at a specific time in the future. The buyer is obligated to purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date. Futures contracts are derivative financial agreements and are standardized, meaning they can only be bought in lots. They are traded on exchanges and the terms are the same regardless of who the counterparty is. Forward contracts are similar to futures but are traded over-the-counter (OTC) and have customizable terms that are agreed upon between the two parties. Futures contracts are also one of the most direct ways to invest in oil. The term “futures” is more general and is often used to refer to the whole market or to the people who trade in the futures market.
Example
An oil producer who plans to produce one million barrels of oil over the next year and wants to lock in a guaranteed price, despite the volatility of oil prices, can use a futures contract. This is an agreement to sell the oil at a pre-determined price at a specified time in the future. In this case, the oil producer can enter into a one-year oil futures contract, which is priced at $78 per barrel. The price is determined by a mathematical model that takes into account various factors such as the current spot price, the risk-free rate of return, time to maturity, storage costs, dividends, dividend yields and convenience yields. By entering into this contract, the producer is guaranteed to receive $78 million in one year, regardless of where the spot market prices are at the time of delivery. They will be obligated to deliver one million barrels of oil at the set price of $78 per barrel.
Types of Futures Contracts
· Agricultural Futures
· Energy Futures
· Metal Futures
· Currency Futures
Forward Contract
A forward contract is a type of agreement between two parties to buy or sell an asset at a specific price at a future date. It can be used for both hedging and speculation, but it is commonly used for hedging as it can be customized to the specific needs of the parties involved. The asset being traded can be a commodity such as grains, metals, or oil, and the contract can be settled in cash or through the physical delivery of the commodity. Unlike standard futures contracts, forward contracts are not traded on a centralized exchange and are considered over-the-counter (OTC) instruments. This allows for more flexibility in terms, but also increases the risk of default as there is no centralized clearinghouse.
Example
Consider the following example of a forward contract. Assume that an agricultural producer has two million bushels of corn to sell six months from now and is concerned about a potential decline in the price of corn. It thus enters into a forward contract with its financial institution to sell two million bushels of corn at a price of $4.30 per bushel in six months, with settlement on a cash basis.
In six months, the spot price of corn has three outcomes:
· It is exactly $4.30 per bushel. In this case, no monies are owed by the producer or financial institution to each other and the contract is closed.
· It is higher than the contract price, say $5 per bushel. The producer owes the institution $1.4 million, or the difference between the current spot price and the contracted rate of $4.30.
· It is lower than the contract price, say $3.50 per bushel. The financial institution will pay the producer $1.6 million, or the difference between the contracted rate of $4.30 and the current spot price.
Risks of Forward Contracts
- As details of the forward contracts is restricted between the buyer and the seller and is not known to the general public, the size of the market is difficult to estimate
- Default risk
- Another risk that arises from the non-standard nature of forward contracts is that they are only settled on the settlement date and are not marked-to-market like futures.
Option Contracts
An option is a financial contract that gives one party the right, but not the obligation, to buy or sell a specific amount of an asset at a specific price, called the exercise price, before a certain date. This contract is known as a call option or a put option. When buying an option, the buyer is essentially purchasing the right to either buy or sell the underlying asset, such as a commodity or stock, at a specific price and at a specific time. The option buyer can choose to exercise this right and execute the contract or choose not to and let the contract expire. The option issuer is legally obligated to follow the terms of the contract if the option is exercised. In summary, buying an option is purchasing the right to buy or sell an asset, as outlined in a contract between the buyer and issuer.
Call Options
A call option is a financial contract that gives the buyer the right, but not the obligation, to purchase bonds, stocks, commodities and other securities at a predetermined price or spot price at a specific date, known as the exercise date or expiration date. The buyer pays a premium for this right and expects the price of the underlying asset to increase within a certain timeframe. The holder of the call option has the choice to either exercise the option and purchase the underlying asset or let the option expire or sell the option contract before the expiration date. The decision to buy or sell a call option is based on the expectation of how the price of the underlying asset will move.
Put Options
A put option is a financial contract that gives the buyer the right to sell a stock at a specific price until a specific date, known as the expiration date. The investor in the put option expects the price of the underlying stock to decrease below the strike price, which is the fixed and predetermined price at which the put buyer can sell the underlying asset. As the value of the put option increases when the stock price goes down, the holder can choose to sell the option when the stock price is low, but if the stock price does not decrease, the contract can be allowed to expire.
Swap Contracts
Interest-Rate Swaps
Plain vanilla interest rate swaps are the most commonly used type of swap. Swaps enable two parties to trade set and variable cash flows on a loan or interest-bearing investment. This is useful for businesses or individuals who want to secure cost-effective loans, but their preferred loan solutions are not available in their chosen market. For example, an investor may be able to get a cheaper loan with a floating rate, but they would prefer a fixed rate. Interest rate swaps allow the investor to change the cash flows to meet their preference.
Currency Swaps
The volume of money exchanged in currency markets is higher than any other market, and currency swaps provide a convenient method for managing foreign exchange risk.
Assume an Australian company is setting up a business in the UK and needs GBP 10 million. Assuming the exchange rate between the Australian Dollar (AUD) and British Pound (GBP) is 0.5, the total amount would come to AUD 20 million. A company based in the UK intends to establish a plant in Australia and requires AUD 20 million. The interest rate for foreign loans in the UK is 10%, while for local loans it is 6%. Meanwhile, in Australia, the interest rate for foreign loans is 9%, and for local loans it is 5%. Apart from the high loan cost for foreign companies, it might be difficult to get the loan easily due to procedural difficulties. Both companies have a competitive advantage in their domestic loan markets. The Australian firm can take a low-cost loan of AUD 20 million in Australia, while the English firm can take a low-cost loan of GBP 10 million in the UK. Assume both loans need six monthly repayments.
Both companies then execute a currency swap agreement.
Credit Default Swaps
The credit default swap offers insurance in case of default by a third-party borrower. Assume Peter bought a 15-year long bond issued by ABC, Inc. The bond is worth $1,000 and pays annual interest of $50 (i.e., 5% coupon rate). Peter worries that ABC, Inc. may default so he executes a credit default swap contract with Paul. Under the swap agreement, Peter (CDS buyer) agrees to pay $15 per year to Paul (CDS seller). Paul trusts ABC, Inc. and is ready to take the default risk on its behalf. For the $15 receipt per year, Paul will offer insurance to Peter for his investment and returns. If ABC, Inc. defaults, Paul will pay Peter $1,000 plus any remaining interest payments. If ABC, Inc. does not default during the 15-year long bond duration, Paul benefits by keeping the $15 per year without any payables to Peter.
Benefits: The CDS works as insurance to protect lenders and bondholders from borrowers’ default risk.
Conclusion
To conclude, derivatives are financial instruments that are derived from underlying assets, such as stocks, bonds, commodities, and currencies. There are various types of derivatives, including options, futures, swaps, and forwards, each with its own unique characteristics and uses. Options give the holder the right, but not the obligation, to buy or sell the underlying asset at a predetermined price, while futures are contracts to buy or sell an underlying asset at a set date in the future. Swaps are agreements between two parties to exchange the cash flows of two financial instruments, and forwards are contracts to buy or sell an underlying asset at a set price for delivery at a future date. Each type of derivative has its own advantages and disadvantages, and the choice of which one to use will depend on a variety of factors, such as the investor’s goals, risk tolerance, and market conditions.
Do check the below source links for more information on the discussed topics,
- Futures Contract Definition: Types, Mechanics, and Uses in Trading
- Forward Contract: How to Use It, Risks, and Example
- Black-Scholes Model: What It Is, How It Works, Options Formula
- BEFORE Trading Options Learn The Greeks | Options Trading For Beginners
- Meet the Options Greeks | Trading Options Course
- Option Greeks
- Option Greeks: The 4 Factors to Measure Risk
- Best Option Trading Strategies — Every Trader Should Know
- Different Types of Swaps
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