As the name suggests, a Derivative is a financial contract that derives its value from the underlying asset. These underlying assets can be stock, currencies, commodities, and more. There are several derivative instruments that an investor uses primarily for two objectives – hedging and speculating. Derivative instruments are among the complex financial instruments, but they offer hefty rewards as well.
Following are the types of derivative instruments:
A futures contract is a contract between two traders for the purchase and delivery of an asset at a specific price at a future date. These are standard contracts and are traded on an exchange. There is an obligation between the two parties to fulfill the commitment, i.e., to buy or sell the underlying asset. Traders use a futures contract to hedge their risk or speculate on the price of an underlying asset.
For example, Company A buys a three-month futures contract for oil for $20 per barrel. Here, Company A could be a shipping company that is worried that the oil price may rise three months later.
Thus, to ensure that it doesn’t lose money due to high oil prices in the future, Company A enters into a futures contract. The other party now will have to deliver oil to Company A at $20 per barrel after the expiry.
Assume after three months, the oil price rise to $30 per barrel. Now, it is up to Company A to accept the delivery of oil. If it doesn’t need the oil, then Company A can also sell the contract before expiry.
Both parties may be hedging risk. The seller could be an oil company, that is worried about dropping the price and thus, want to lock in a futures contract at which it won’t be at a loss. It is also possible that both parties are just speculators. In such a case, it is unlikely both parties would intend for the delivery of oil.
These are similar to the futures contracts; the only difference being they do not trade on any exchange. Instead, they are OTC (over-the-counter) contracts. Also, these are not standardized contracts like futures. Buyers and sellers have an option to customize the terms of the contract, such as size, settlement process, and more.
Since they are OTC, forward contracts carry a higher counterparty risk for both parties. Counterparty risk is a risk where either party may fail to fulfill the obligation. If one of the parties fails to meet its commitment, the other party may have no recourse.
The counterparty risk increases if the buyer and seller offset their position with other counterparties. Now, the same contract would have more parties, which magnifies the risk.
It is another popular derivative instrument and is similar to futures contracts. Options also allow the buyer and seller to agree to buy or sell the underlying asset at a future date and at a specific price. However, with options, there is no obligation on the buyer to exercise the agreement.
In the option contract, the buyer gets the right to buy or sell the underlying asset. However, the option buyer has no compulsion to buy the deal at the expiry. Options are of two types – Call and Put.
Under the call option, the holder has a right to buy the underlying asset at a future price and date. But the holder is under no compulsion to exercise his right to purchase. In a similar way, the put option gives the holder the right to sell the underlying asset. But again, the holder is under no compulsion to sell.
Based on when a trader can exercise the option, there are two types of options – European and American options. Under the European variant, the buyer can use the option on the maturity date, while a holder can exercise American options anytime before maturity.
For example, Company A owns ten shares worth $10 per share. To hedge the position, Company A buys a put option, which gives it the right to sell the shares at $10 at a future date. Now, assume that at the expiry date, the share price drops to $8. The buyer of the option exercises the option and sells the shares at $10. Assume the cost of the put option was $5. In this case, the loss of the buyer was only $5.
In another example, assume Company A expects shares of XYZ to gain next month. Company A does not own the shares of XYX, whose current price is $10. Thus, Company A buys call options worth $2, which gives it the right to purchase shares of XYZ on or before the expiry.
Now assume that the share price rose to $12. Company A will now use the option to buy the shares, which are worth $12, at $10. It means a profit of $2 per share, excluding option costs.
In both – the call and put – option, the seller must fulfill the contract if the buyer wants.
It is an agreement that allows an investor to exchange one security with another. The objective of the exchange is to change the terms that each investor is subjected to. Usually, there is a swap of fixed cash flow with the floating or vice versa. Interest rate, commodity, and currency swaps are the most common types of exchanges.
For example, Company ABC has a loan of $10,000 at a variable interest rate of 10%. Company ABC, however, is worried that the interest rate may rise significantly in the future. Thus, it enters into a swap agreement with Company XYZ, which is ready to exchange the 10% variable rate with a 12% fixed rate.
Now, Company ABC will pay interest at 12% to Company XYZ, who, in turn, would pay interest at 10% to the lender. In reality, the parties pay only the difference amount, in this case, 2%.
A few months later, the interest rate drops to 8%. Company ABC will now have to pay a 4% difference to Company XYZ. But, if the interest rate goes up, suppose 14%, the Company ABC would continue to pay a 2% difference, while Company XYX will pay the other 2%.
Swaps are a private agreement and thus carry a high amount of risk. Swaps are also risky because interest and currency – its most popular underlying assets – are itself volatile.
Derivative instruments allow an investor to bet against an increase or decrease in the price of the asset. They have emerged as popular tools to either hedge risk or make money by speculating. However, they are risky, as well. A sizeable adverse movement could result in massive liability for a trader. Since they are complex instruments, these should not be the go-to tools for beginners.