Derivatives

These are financial instruments that derive value from an underlying asset, asset group, or benchmark. 

The word derivative simply means something is related to or based on another thing. In finance terms, derivatives are financial instruments that derive value from an underlying asset, asset group, or benchmark. 

Derivatives

Because a derivative's value is dependent on the underlying asset, there is a very high degree of correlation between the price movement of a derivative and its underlying. 

Although this is the case, most derivatives are leveraged. Not only does this mean increased volatility, but risk assumption with increased leverage means extra costs also impact the derivative's price changes, regardless of the underlying price movement. 

These can derive value from all sorts of assets. Common examples include the following:

  • Equities and Equity Indices 
  • Bonds
  • Currencies
  • Commodities
  • Interest Rates

From these underlying assets, many types of derivative contracts can be created. Of these, the most common are the following:

  • Options
  • Futures
  • Forwards
  • Swaps 

Why would an investor purchase an asset that derives its value from an underlying asset rather than just the asset itself? As was briefly aforementioned, derivatives typically are leveraged. This allows investors to either hedge risk or speculate. 

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Where are these traded? When looking at the derivatives market, we can identify multiple parties participating, one assuming the risk and another paying for increased leverage. These contracts are traded over the counter (OTC) or on an exchange. 

For OTC derivatives, there is a greater degree of what is known as counterparty risk. Counterparty risk is simply the risk that one of the parties involved in the contract defaults on their obligation.  

Options

Options are a type of financial instrument used to speculate on the price of a security. As a derivative contract, its value is determined by changes in the underlying security price. 

We see options, contracts, calls, and puts in the following window. The call options are highlighted on the left.

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Source: TD Ameritrade IP Company, Inc

An equity call option allows the owner the right to buy 100 shares of the underlying for a certain price, as long as it is before the expiration date of the contract. Put options instead, giving the right to sell those 100 shares. 

diagram

While there are many reasons that a stock option may change its value, only a few basic components are needed to understand options and their applications. e are:

AAPL

Source: TD Ameritrade IP Company, Inc

 

For this AAPL weekly call expiring September 9, 2022, buyers pay a premium of $0.96, also known as the ask.  

An option contract strike determines what is known as "moneyness." An in-the-money contract is one where the underlying price is above the strike for call options. Conversely, a price below the strike would mean the option is out-of-the-money. 

For put options, the moneyness and strike price relationship is the opposite. A price above the strike means the contract is out of the money, while a price below the strike means the contract is in the money.

For American options, the expiration date is the last date an option contract can be exercised, although they are sometimes exercised before. European options can only be exercised on their expiration date. 

There is no benefit to exercising an out-of-the-money contract. For this reason, contracts are typically only exercised when in the money. 

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Even with American options, early exercising is not common. Instead, investors tend to exit their position by selling the option contract to another investor. In cases where the investor originally went short, they repurchase the option contract sold. 

An option contract premium is both the price of purchasing the options and what the seller of the option collects. Premium is expressed as a price per share on the contract itself. This means the contract's price is 100 times the premium, as a contract controls 100 shares.

Contract Price = Premium x 100 shares

A simple way of understanding premium is considering the price an investor is willing to pay to have the temporary leverage an option contract offers. Investors only need to pay the premium rather than the price of 100 shares. 

Because the contract represents 100 shares, the investor needs to remember that its price changes rapidly, especially as the option becomes closer to its expiration date. Therefore, if the investor's portfolio contains many options, it will likely be volatile.  

Futures

Like options, futures contracts focus on exchanging underlying security at some time in the future. However, unlike an options contract, which gives the buyer the right to exercise, futures contracts buyers must purchase the underlying contract at the set date. 

excel chart

A futures contract includes several components:

  • Trading hours
  • Contract size
  • Tick size
  • Contract value, otherwise known as notional value
  • Delivery specifications

Each futures contract has trading hours depending on the commodity or financial instrument. 

Contract size represents how much of the underlying asset the futures contract controls. For example, oil futures are always standardized at 1,000 barrels. 

The tick size is the smallest change that can be recorded in contract value. For example, oil changes are only quoted in cents rather than parts of a cent. That means that one tick movement would be $10, as the contract controls 1,000 barrels. 

The contract value is how much the contract is worth and can be calculated by multiplying the contract size by the current market price. 

phone and bullish trend

Delivery specifies the way the contract is settled, either financially or physically. For institutional buyers, the goal is typically physical settlement, while for retail investors speculating on price, the goal is a financial settlement.

For contracts that are typically physically settled, investors must close the position to avoid product delivery. 

Like option contracts, futures can hedge risk or speculate on the direction of future price movements. Let's take a look at an example using wheat. 

sunset

Sellers of the wheat futures contract would be the farmers, whereas the buyers are bread manufacturers that will continue to need wheat in the future. 

To hedge risk, bread manufacturers lock in a price that would be beneficial if prices go up. Losses on the contract from decreasing prices are offset by cheaper purchases of the commodity at the spot price. 

Farmers are also hedging risk in this situation. If prices go up, their losses on the contract are offset by other wheat sales at high prices. Decreasing wheat prices are less damaging, as they are locked into valuable agreements to sell wheat for higher prices via futures contracts. 

Forwards

Forwards contracts work similarly to futures contracts but are slightly different. While futures contracts trade in exchanges, forwarded contracts are typically private agreements between buyers and sellers and rarely trade.

forwards

In terms of structure, forward contracts work quite similarly to futures contracts. The only differences are that the specifications are negotiated between parties. There is no specified contract size, for example. 

As a result, forward contracts are said to be over-the-counter (OTC) instruments. The lack of exchange makes the default risk of these contracts much higher than futures contracts. 

A relatively easy-to-follow example of a futures contract is an exchange rate quote. This can be used by manufacturers who buy parts from foreign factories. To purchase these components, they must first purchase the foreign currency. 

In this example, the forward contract is being used to hedge risk. If the foreign currency strengthened relative to the domestic currency, purchasing foreign goods would be more expensive. 

line chart

Because the manufacturer would rather not assume the risk of increased prices, they enter into a forward contract. However, by doing so, the manufacturer is foregoing the opportunity to benefit from a beneficial exchange rate shift. 

In addition to being used as a risk hedging tool, forwards can also be used to speculate. If the purchase of a forex forward contract locks in an exchange rate, they could profit on the price difference in exchange rates if the rates shift in a beneficial direction. 

For example, let's say an investor is quoted and the forward rate in which currency A can be traded for 2 of currency B. After one year, when the transaction is settled, currencies A and B are at parity, meaning that 1 unit of currency A can be exchanged for 1 unit of currency B. 

Using the forward exchange rate agreed upon previously, the investor can double their domestic currency, in this example A. Then, they exchange the agreed-upon amount for currency B and immediately repurchase currency A at the spot exchange rate. 

Swaps

Swaps are agreements between two parties where cash flows are traded and switched for a specified period. As such, they are also considered OTC derivatives. The most common examples of swaps track interest rates and currencies.

dollars

Typically, swaps contain one fixed interest payment and one variable payment. The corresponding sequence of cash flows is exchanged between the two parties for the agreed-upon period. 

During this period, the two parties exchange cash flows at the agreed-upon settlement dates, broken up by what is known as settlement periods. 

A hypothetical example of what is known as a plain vanilla interest rate swap would be the following:

  • Company A agrees to pay 3% interest to company B on a notional amount of 10 million.
  • Company B agrees to pay the current Federal Funds Rate (FFR) +1% to company A in a notional amount of 10 million. 

If, at the end of the year, the FFR is 2.25%, company B will be liable for $325,000 to company A. Offset by the $300,000 payment, Company A agreed to pay company B, and company A nets $25,000. 

buildings

Swaps like this are set up for two main reasons, commercial needs, and comparative advantage. 

The above example would match up well with the commercial needs side. For instance, if company A were a bank, the floating interest payments would be beneficial. This is because bank account deposit liabilities are variable rates, whereas their extended loans are fixed. 

By entering a swap, the bank can have some variable rate income that matches up more closely with their outstanding liabilities; hence it satisfies their commercial needs. 

On the comparative advantage side, currency-based swaps would be more relevant. For example, a favorable swap could be agreed upon if one American company was looking to expand into Europe and a European company was looking to expand into the United States. 

Both companies need foreign currency but would likely find better financing terms domestically. By creating a swap, both companies can discover more advantageous rates for foreign currency. 

Conclusion

Many financial instruments derive value from other things. In the world of finance, these securities are known as derivatives.

weight scale

Common examples of derivatives include options, futures, forwards, and swaps. These contracts can track equities and equity indices, bonds and other fixed income instruments, currencies, commodities, and even interest rates.

These advantages allow investors to hedge risk and speculate on the underlying. Smaller amounts of capital are needed to control them than what would be required to control the same amount of the underlying. 

Because of the increased leverage, these contracts are much more volatile. While volatility is a risk in itself, derivatives also have counterparty risk, which makes returns even more unpredictable. 

For these reasons, it is recommended that investors looking to incorporate derivatives into their investment strategy have a strong understanding of the contracts themselves and anything that could affect the underlying asset. 

For equity-based contracts, such as options, fundamental stock analysis is needed to form a more complex strategy than simply gambling. 

Other types of derivative contracts should also be approached with care. For example, understanding macroeconomics is recommended for interest rate-based contracts. Likewise, fixed income valuation should be understood for bond-based derivatives.

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Researched and Authored by Jacob Rounds | LinkedIn

Reviewed and Edited by Sakshi Uradi | LinkedIn

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