A Complete Guide on Financial Derivatives | A Money-Making Machine?

Derivatives

"Derivative", the word itself sounds interesting, isn’t it?

A Derivative is often misunderstood as a quick money-making financial security, but is it so?

This article is focused on building up the foundation of Derivatives, in the easiest possible way and will provide answers to a lot of questions, just like the one asked above.

As Derivatives has a lot of aspects to it and to make it easy to understand, we will be splitting the article in the form of questions. Let’s get started.

What is a Derivative?

A derivative is a financial contract whose value is dependent on the underlying asset. There are two parties to the contract, one being the seller and the other being the buyer.

What are the different underlying assets?

1) Interest rate
2) Equity
3) Commodity
4) Market Indices
5) Bonds
6) Currencies

Participants in the derivatives markets:

1) Hedgers: These are usually big investors, who use derivatives to reduce or eliminate the risk associated with the price of an asset. They take opposite positions in the derivatives market by paying a small amount of premium, which compensates the risk of price change with respect to their actual holdings.

2) Speculators: These are traders who bet on the price movements of an asset. Speculators are usually retail investors who want to make quick money, but the fact is 90% of speculators end up losing money in the market due to the lack of knowledge. 

3) Arbitragers: These people take advantage of price differences of a similar asset across various markets. The basic rule of arbitrage is “Buy low, sell high”.

Bifurcation of Derivative Markets:

1) Commodity derivatives market: In this market different types of commodities are traded such as:

(i) An agricultural commodity like wheat, coffee, cotton, soybeans, meat products, dairy products, etc.
(ii) Precious metals like gold, silver, etc.
(iii) Energy products like crude oil, natural gas, coal, etc

2) Financial Derivative Markets: In this market different types of financial assets are traded such as:

(i) Equity
(ii) Interest rates
(iii) Currencies
(iv) Bonds

Different types of Derivative contracts:

There are four types of derivative contract such as Forward Contract, Future Contract, Options, and Swaps.

1) Forward and Futures are kind of very similar contracts, hence the below table will provide detailed comparison of the same:



Forward Contract

Future Contract
An agreement between the parties to buy and sell a particular underlying asset for cash in the future at a pre-determined price and date.

An agreement between the parties to buy and sell a particular underlying asset for cash in the future at a pre-determined price and date.
These are OTC contracts (over the counter) i.e. there is no middle man involved in the transaction.

These are Exchange-traded contracts i.e. one can buy or sell only through the stock exchange.
Unregulated, as there is no one involved other than the buyer and seller of the contract

Due to the presence of exchange, these contracts are highly regulated.
These contracts can be customized as per the requirement of parties such as deciding the period, lot size, etc.

These contracts are standardized as the period and lot size is decided by the exchange.

As they are not regulated, there is a high probability of default, thus there is a huge risk involved in Forward contracts.


As they are regulated by the Exchange, which has certain norms such as mark to market, margin money, etc. and thus the risk is apparently very low or nil.

Forwards are only settled on the maturity date.
Futures are settled on a daily basis by the Exchange, these daily settlements are also called mark to market.

There is no collateral required to enter in a forward contract.
The buyer has to deposit an initial margin with the stock exchange to enter in a future contract.

 Low liquidity, as there are only two parties involved in the transaction
High liquidity: As it is an exchange-traded contract, the parties can easily exit their positions.



3) Options:

ü  An option is a contract that gives the right, but not the obligation, to buy or sell the underlying asset at a pre-determined price and date.
ü  An option buyer pays the premium to the option writer (one who sells the option) in order to purchase the rights.
ü  The option can be either to buy or sell a particular underlying asset.
ü   The option writer is obliged to buy or sell the underlying when the option buyer wishes to exercise his right.

Options are of two types:



Call Option

Put Option
A call option gives the option buyer the right, but not the obligation to buy the underlying asset at a pre-determined price by exercising his right, before the option lapses

A put option gives the option buyer the right, but not the obligation to sell the underlying asset at a pre-determined price by exercising his right, before the option lapses



Exercising an option depends on the nature of the option:
  • A “European option” can be exercised only on the option expiry date
  • An “American option” can be exercised at anytime before the option expires.
4) Swaps:

These are OTC contracts, i.e. it is not traded on the stock exchange and hence these are private agreements between two parties to exchange cash flows in the future depending on the type of swap. Swaps work on speculation of the parties.

There are total 6 types of swaps and the two most commonly used are Interest rate swap and the Currency swap.

(i) Interest Rate Swap:

In such swap, the parties in the contract exchange interest rates where one party has a fixed interest rate, and the other has a floating interest rate (also known as variable interest rate). It is a pure speculation-based derivative.

 Let’s understand it with an example.

Anuj has a loan of Rs. 1 Lakh on which he is paying a fixed interest of 5% p.a.

Rahul also has a loan of Rs. 1 Lakh on which he is paying a variable interest of 2% p.a.

They both enter in Interest rate swap agreement, where Anuj is predicting that in the next 10 years the floating rate will not increase by more than 4%, while on the other side Rahul is speculating that in the next ten years the floating interest might increase up to 10%.

Ultimately only one party will benefit and the other would lose. It’s a zero-sum game.

(ii) Commodity Swap:

In such a swap, a commodity such as gold, petroleum product, crude oil, etc. is swapped between two parties. Usually, two countries, use commodity swap to exchange a particular commodity at a particular price and for a particular period.

(iii) Currency swap:

In such swap agreement, the two parties exchange principal amount and the interest on the loan in one currency for principal amount and interest in another currency.

Let’s understand it with an example.

Suppose a US-based company can borrow loan in the US at 5%, whereas an Australian company can borrow loans in Australia at 6%.

If the same companies want to start their business in each other’s country, they would need to take loans in the respective country, suppose US-based company willing to start their business in Australia will get loan at a higher interest rate, let’s say the rate would be 10%, and similarly, an Australian company will get loan in the US at, let’s say 9%.

Now in this scenario, both the parties can enter in a Currency Swap and exchange fixed for fixed interest rates, so they can avoid paying higher rate.

For explanation, a US-based company will take X amount of loan at 5%, whereas an Australian company will take X amount of loan at 6% in their own countries and later exchange the principal and interest with each other.

In this case, both the companies are getting benefits by getting cheaper loans.

(iv) Some other swaps are Total Return Swaps, Credit Default Swaps, and Debt-Equity Swaps.

So, this was all about "A Complete Guide on Financial Derivatives", in the next article we would be digging deeper to find out “How to calculate option prices?”, Greeks and many more interesting topics. Stay tuned, Stay Educated!

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