Chapter 2: Understanding Derivatives

Objective

In this chapter you will learn about derivative contracts. You will learn what are derivatives, why they exist, types of derivatives and how they work. We will also see advantages and disadvantages of derivatives contract.

Section 2.1

What are Derivatives?

Definition: A derivative is a financial instrument whose value is derived from the value of an underlying asset, index, or rate. It is essentially a contract between two or more parties to exchange cash flows based on the price movement of an underlying asset.
- The underlying asset could be a commodity (like oil, gold), a stock, a bond, a currency, or an index (like the Nifty 50 or S&P 500).
- Derivatives allow market participants to speculate on the price movements of these assets, hedge existing risks, or arbitrage price differences between markets.

Basic Structure:

In derivatives, the buyer and seller agree to a transaction based on an underlying asset, with terms set for a future date.
Examples of derivatives include futures contracts, options contracts, forwards, and swaps.

Section 2.2

Why Do Derivatives Exist?

Hedging: Derivatives provide a mechanism for managing or mitigating risk. For instance, farmers can use futures contracts to lock in prices for their crops before harvest, protecting themselves from price fluctuations.

Example: An airline company might use fuel futures to hedge against rising oil prices.

Speculation: Traders can use derivatives to speculate on the price movement of an underlying asset. Unlike investing in the asset itself, derivatives offer leverage, meaning a small investment can lead to larger returns (or losses).

Example: A trader may speculate that the price of gold will rise, and purchase a gold futures contract.

Arbitrage: Derivatives are also used to take advantage of price differences between different markets. Arbitrageurs buy low in one market and simultaneously sell high in another market to lock in a risk-free profit.

Example: Buying a stock in one market at a lower price and selling it in another market at a higher price.

Section 2.3

Types of Derivatives

There are several types of derivatives, each with its unique characteristics, uses, and risks. Here are the most commonly traded types of derivatives:

Forward Contracts
- A forward contract is a private, over-the-counter (OTC) agreement between two parties to buy or sell an asset at a specified price on a future date.
- Unlike futures contracts, forwards are customizable and traded off-exchange, which can lead to counterparty risk (the risk that one party will not fulfill the contract).
- Example: A company may enter into a forward contract to purchase foreign currency at a fixed rate for a transaction that will occur in the future.

Futures Contracts

A futures contract is an agreement to buy or sell an asset at a future date for a predetermined price, with the terms standardized by the exchange.
Unlike forwards, futures are traded on exchanges (like the NSE, CME), which helps reduce counterparty risk. The contracts are marked to market daily, meaning gains and losses are realized and settled at the end of each trading day.
Example: A futures contract on crude oil might stipulate that the buyer must purchase oil at $75 per barrel in three months.

Options Contracts

An options contract gives the holder the right (but not the obligation) to buy or sell an underlying asset at a predetermined price (strike price) before or at a specific date (expiration date).
There are two main types of options:
- Call Options: Gives the holder the right to buy the underlying asset.
- Put Options: Gives the holder the right to sell the underlying asset.
Example: A stock option might give the holder the right to buy 100 shares of XYZ Corp. at $50 per share within the next month, even if the market price rises to $60.

Swaps

Swaps are derivative contracts in which two parties agree to exchange future cash flows based on different underlying assets. The most common types are interest rate swaps and currency swaps.
Interest Rate Swaps: Involves exchanging fixed interest rate payments for floating rate payments.
Currency Swaps: Involves exchanging cash flows in different currencies, typically used to hedge against currency risk.
Example: A company may enter into an interest rate swap to exchange its fixed-rate debt payments for floating-rate debt payments if it believes interest rates will fall.

Section 2.4

How Derivatives Work

Derivatives derive their value from the performance of an underlying asset. This can include anything from stocks, commodities, currencies, or interest rates. The basic principle of derivatives trading is that the price of the derivative moves in tandem with the price movement of the underlying asset.

Leverage: Derivatives are known for their use of leverage, meaning a relatively small amount of capital can control a larger position in the underlying asset. This magnifies both potential returns and potential losses.
- For example, with a 10% margin requirement, an investor can control $100,000 worth of a commodity by investing only $10,000.

Mark-to-Market: Futures and other exchange-traded derivatives are “marked to market” daily, which means that the value of the contract is adjusted based on the closing price of the underlying asset. Any gains or losses are realized, and the margin account is adjusted accordingly.
Settlement:
- Some derivatives, like futures contracts, can be physically settled, meaning the actual delivery of the underlying asset occurs at contract expiration.
- Others, like options and some futures contracts, can be cash-settled, where only the difference in price between the contract and the market price is exchanged.

Section 2.5

Key Characteristics of Derivatives

Leverage: Derivatives provide leverage, which means that an investor can control a large position in an asset with a relatively small amount of capital. However, while leverage can increase profits, it also amplifies losses.
- Example: Buying one futures contract may control 100 units of an underlying asset, like a commodity, with a margin requirement of just 10%.
Hedging: One of the primary uses of derivatives is to hedge against price fluctuations in underlying assets. Investors and businesses use derivatives to lock in prices or interest rates.
- Example: A company expecting to pay for imported goods in foreign currency in six months might enter into a currency futures contract to lock in the exchange rate.

Speculation: Speculators use derivatives to bet on the future price movements of assets. This allows them to profit from price movements without owning the underlying asset.
- Example: A trader might buy a futures contract on oil, speculating that oil prices will rise.
Liquidity: Derivatives markets often provide higher liquidity than the underlying spot markets, particularly in highly traded futures and options contracts.
- Liquidity ensures that participants can enter and exit positions quickly without causing significant price movement.

Counterparty Risk: In the case of over-the-counter (OTC) derivatives (like forwards and some swaps), there is a risk that one party might default on the contract.
- To reduce counterparty risk in standardized derivatives, exchanges act as intermediaries, guaranteeing contract performance.

Section 2.6

Advantages and Disadvantages of Derivatives

Advantages:
- Risk Management (Hedging): Derivatives allow individuals and institutions to hedge against price volatility and currency fluctuations.
- Leverage: With derivatives, traders can gain exposure to a large position with a relatively small investment.
- Diversification: Derivatives allow investors to diversify portfolios by gaining exposure to asset classes they may not otherwise have access to, such as commodities or foreign currencies.
- Price Discovery: Derivatives markets play a key role in price discovery, providing a forward-looking view on the prices of underlying assets.

Disadvantages:

Complexity: Derivatives can be complex instruments, requiring a deep understanding of the underlying markets and risks.
Risk of Large Losses: Due to leverage, small movements in the price of the underlying asset can result in significant profits or losses.
Counterparty Risk: In OTC derivatives, there is the possibility that the counterparty may fail to fulfill the contract, leading to a default.
Speculative Nature: If used for speculative purposes, derivatives can lead to excessive risk-taking and market instability.

Section 2.7

Regulatory Environment of Derivatives

Role of Regulators: Regulatory bodies, such as the Securities and Exchange Board of India (SEBI) and the Commodity Futures Trading Commission (CFTC) in the U.S., oversee derivatives markets to ensure they operate transparently, fairly, and without causing systemic risk.
Clearinghouses: In organized exchanges, clearinghouses act as intermediaries to reduce counterparty risk by ensuring that trades are completed even if one party defaults.
Regulations on Margin and Leverage: Derivatives markets are heavily regulated, especially regarding margin requirements and the amount of leverage that can be used in trading to prevent excessive speculation.

Final Takes

Conclusion

Derivatives are powerful financial instruments used by a variety of market participants for hedging, speculation, and arbitrage. They provide a way to manage risk and gain exposure to a wide range of underlying assets without directly owning them. However, due to their complex nature, they also carry significant risks, particularly in terms of leverage and counterparty risk. Understanding derivatives is crucial for mastering Futures and Options (F&O) trading, as these are the instruments at the heart of the derivatives markets.

In the next chapters, we will dive deeper into Futures and Options contracts, understanding their specific mechanics, strategies, and how they are used in practice.