What Are The Different Types Of Derivatives?
Forwards, Futures, Options, Swaps
Investors put their money in the crypto markets with the hope to make good returns on their investments. Many potential investors however stay away from the markets due to the volatility in the markets. As crypto markets become more volatile the risk on investments also increases. This means an investor could make greater profits or greater losses depending on the direction in which the market moves. Therefore, a price movement in a certain cryptocurrency has the power to provide high returns on their investments or wipe out the entire investments if the market crashes severely. As seen from the graph below, Bitcoin was once trading about $60,000 but is now trading at around $30,000 in a span of 2 months.
To protect traders from this increased volatility and also to speculate on the price action of cryptocurrencies there are many financial instruments that are available in the market. These financial instruments are called derivatives, which are contracts that derive their value from the underlying cryptocurrency.
This blog covers everything you need to know about derivatives and some of the most commonly used derivatives in the financial markets.
What are derivatives?
Derivatives are contracts that derive their value from the underlying assets. The commonly used assets could by stocks, bonds, commodities and even cryptocurrencies. As the value of the underlying asset keeps changing, the reason for entering a derivatives contract is to earn profits by speculating on the price of that asset or minimizing the loss by hedging the risks for that asset.
There are many advantages of derivatives. Some of them are -
- Underlying Asset Price Determination — Derivatives are frequently used to determine the price of the underlying asset. For example, the spot prices of the futures can serve as an approximation of the cryptocurrency’s price.
- Arbitrage — Arbitrage trading involves buying an asset or security at a low price in one market and selling it at a high price in the other market. In this way, you are benefited from the differences in prices of the commodity in the two different markets.
- Hedging Risk Exposure — A price fluctuation of an asset may increase your probability of losses. Traders can either purchase a derivatives contract to shield themselves against a fall in the price of the asset or to safeguard against a rise in the price of an asset that they are planning to buy.
- Access To Unavailable Assets Or Markets — Derivatives can help organizations get access to otherwise unavailable assets or markets. By employing interest rate swaps, a company may obtain a more favourable interest rate relative to interest rates available from direct borrowing.
So you might be wondering who are these people who trade in the derivatives market. They are mostly -
- Hedgers — These are risk-averse traders who aim to take opposite positions in the derivatives market to hedge against the risk of loss in the spot market. These traders need to pay a premium that is a lot less than the losses that they might incur. For example, I have purchased BTC at $31,000 and expect the price of it to rise in the next 1 month. In the meantime, I am still unclear about the market view and do not want to lose out on my investment or face any losses. To hedge my risks against the price fall, I will buy a put option contract by paying a nominal premium for the contract.
- Speculators — There are several risk-takers in the market who are ready to take risks for fewer profits. They function in a completely opposite manner as compared to hedgers. Unlike the hedgers in the above example, a speculator could be an options writer who sold this contract. So, as long as the price of Bitcoin does not fall, the put option will not be exercised and the speculator who in this case is the option writer keeps the premium and has made that as a profit. We say he is risk-averse because, for an options writer, there is no limit to losses.
- Margin traders — These are traders who need a deposit of a limited amount of money which is called margin. Based on the amount of margin deposited, traders can use it to get leverage in the market. For example, I might have a $50 margin but I can still long a $200 cryptocurrency by using 4x leverage on the platform. Not considering any interest rate charges on the borrowed money, a fall in the price of the cryptocurrency to $150 would lead to liquidation on my long order and I would completely lose my funds. A slight price change could lead to greater profits or losses in the derivatives market as compared to the normal stock market.
- Arbitrageurs — These utilize the low-risk market imperfections to make profits. They simultaneously buy low-priced securities in one market and sell them at a higher price in another market. This can happen only when the same security is quoted at different prices in different markets. For example, a cryptocurrency could currently be priced at $1000 and be priced at $1050 in the futures market. In that case, an arbitrageur would continuously buy the stock at the $1000 price till its price keeps going up and at the same time sell it at $1050 in the futures market. Arbitrageurs in this way make low-risk profits from such imperfections.
Now that we know what derivatives are and the different types of people who use them, let us see the different types of derivatives contracts that are accessible to traders.
Popular Types of Derivatives
There are 4 different types of derivatives that are most commonly used in the financial markets. These are
Forward contracts are the simplest and the old form of derivatives that we know. It is an agreement to sell something at a future date. The price at which this transaction will take place is decided in the present.
However, a forward contract takes place between two counterparties. This means that the exchange is not an intermediary to these transactions. Hence, there is an increased chance of counterparty credit risk. Also, before the internet age, finding an interested counterparty was a difficult proposition. Another point that needs to be noticed is that if these contracts have to be reversed before their expiration, the terms may not be favourable since each party has one and only option i.e. to deal with the other party. The details of the forward contracts are privileged information for both the parties involved and they do not have any compulsion to release this information in the public domain.
A futures contract is very similar to a forwards contract. It also mandates the sale of the asset commodity at a future date at a price that is decided in the present.
However, futures contracts are traded on the exchange, unlike forward contracts that are traded over the counter (OTC). This means that an exchange is an intermediary in the case of a futures contract. Hence, these contracts are of standard nature and the agreement cannot be modified in any way. Exchange contracts come in a pre-decided format, pre-decided sizes and have pre-decided expirations. Also, since these contracts are traded on the exchange they have to follow a daily settlement procedure meaning that any gains or losses realized on this contract on a given day have to be settled on that very day. This is done to negate the counterparty credit risk.
An important point that needs to be mentioned is that in the case of a futures contract, the buyer and seller do not enter into an agreement with one another. Rather both of them enter into an agreement with the exchange.
As mentioned earlier, an option is a contract giving the buyer the right, but not the obligation, to buy (in the case of a call option contract) or sell (in the case of a put option contract) the underlying asset at a specific price on or before a certain date. Options are known as derivatives because they derive their value from an underlying asset.
While the buyer of these contracts has the right to exercise the contract, the seller is obliged to do so in case the contract gets redeemed by the buyer.
Swaps are probably the most complicated derivatives in the market. Swaps enable the participants to exchange their streams of cash flows. For instance, at a later date, one party may switch an uncertain cash flow for a certain one. The most common example is swapping a fixed interest rate for a floating one. Swaps help traders move back and forth from fixed interest rates to variable rates, for example, to maximise their yields on their cryptocurrencies.
Trading derivatives is not as easy as buying and selling cryptocurrencies or other assets in the spot market. Traders need to understand the functionalities and purpose of each derivative before using one or a combination of these contracts. While the ones mentioned above are the most common and popular ones there are countless combinations of these 4 basic types that result in the creation of extremely complex contracts.
Despite the benefits of derivatives, there have been disastrous consequences in the financial markets due to derivatives, including the Global Financial Crisis of 2007–2008. Derivatives involve high risk and bring with them a lot of speculative and risky features. While contracts traded on exchanges involve lower counterparty risk, the ones traded over the counter can lead to more defaults as there are higher chances of a counterparty risk.
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