Definition and purpose of derivatives

Derivatives are financial contracts whose value is linked to the performance of an underlying asset, group of assets, or benchmark. Common underlying instruments include stocks, bonds, commodities, currencies, interest rates, and market indexes.
Derivatives may be traded over-the-counter(OTC) that means investor purchase through a broker. Derivatives traded through exchange are regulated and standardized, OTC derivatives are not.
OTC traded derivatives are considered to have high potential risk, where either of one party might be in danger involving issues with the transactions as these are not regulated.

Purpose of derivatives

Hedging Risks:

If an investor is uncertain about whether the price of a particular asset will be higher or lower over a certain period of time, they can use a derivative to protect themselves from potential losses. This basically called hedging, the more exact the hedging is the better for the hedging party.

Speculation:

Investors use derivatives to speculate the future Direction of an underlying asset’s price. If an investor believes that future price is gonna increase substantially then he uses derivatives to make bets on it and buys the asset for today’s price and later sells it for a higher price.

Access to Unavailable Assets or Markets:

Certain markets might be closed to international investors due to some regulations or have exchange rate risk if they are holding those stocks. Derivatives were originally used to ensure balance on international traded stocks. By using these derivatives, the investor can reduce the uncertainty of future exchange rate movements. Essentially, derivatives can provide a financial hedge, allowing the investor to focus on the performance of the investment itself rather than worrying about currency risk.

Leverage:

Derivatives often require a relatively small initial investment, which can provide the effect of leverage. This means that investors can spread their money on different investments to get good returns without putting a lot on any one place. However, leverage also increases the potential for higher losses.

Arbitrage Opportunities:

Arbitrage is the simultaneous purchase and sale of the same or similar asset in different markets in order to profit from tiny differences in the asset’s listed price. Derivatives are well suited for this as they mirror the performance of an actual asset. Arbitrage plays a critical role in financial markets by promoting efficiency and also helps ensure that prices do not deviate significantly from fair values for extended periods.

Types of Derivatives

Derivatives come in various forms, each serving different purposes and offering distinct mechanisms for hedging, speculation, or achieving investment goals. There are two classes in derivatives called “lock” and “options”. Lock refers to binding upon certain terms over the lifetime of a contract for respective parties involved(e.g., futures, forwards, or swaps). Whereas options provide the buyer with the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a certain date (e.g., stock options).

Futures

It is an agreement between two parties to buy or sell a particular asset at a predetermined price which is set in the future. Futures are standardised contracts traded on exchanges and can cover a wide range of underlying assets, including commodities, currencies, and financial instruments. Traders use futures to hedge their risks and speculate the asset’s price.

Let’s consider a scenario involving a coffee shop chain, cafe A, which decides on March 1, 2024, to buy a coffee bean futures contract at a price of $1.80 per pound, set to expire on June 30, 2024. The company chooses to do this as it needs a consistent supply of coffee beans in July for its operations and is concerned that coffee bean prices might escalate due to market volatility or seasonal factors. By locking in a price with a futures contract, cafe A effectively hedges its risk against rising coffee bean prices. If, by the expiration date on June 30, the market price of coffee beans has risen to $2.10 per pound, cafe A has two options. It can take delivery of the coffee beans at the agreed price of $1.80 per pound, realising savings compared to the current market price, or if the chain has found an alternative coffee bean supply at a better rate, it can sell its futures contract before it expires, potentially profiting from the price difference in the futures market.

In the above example both the parties hedged their risk through this futures contract. Cafe A wanted to avoid the risk of coffee price increasing in the month July entering a long position in coffee futures contract. The seller could also be worried about the prices dropping and wanted to avoid the risk. In this case one might benefit from the contract and the other party might not.

Forwards

Similar to futures, forward contracts are agreements to buy or sell an asset at a future date for a price agreed upon today. Unlike futures, forwards are non-standardized contracts that are traded over-the-counter (OTC). When a forward contract is formed buyer and seller may customise the terms, size and settlement process. Forward contracts carry a great risk as they are not regulated and not every average investor is interested in these types of contracts.

Example airline X signs a forward contract on March 1, 2024, to buy 1 million gallons of jet fuel at $3.00 per gallon for September. This secures their fuel costs against potential price rises. If, by September, jet fuel prices increase to $3.50 per gallon, Airline X saves $500,000 by purchasing at the locked-in rate.

However, if Airline X’s operational plans change and it no longer requires the fuel, or if it finds a more cost-effective solution, the airline could negotiate with Fuel Provider to settle the contract at a difference or find another party interested in taking over the contract, potentially leveraging the favourable price difference.

Swaps

Swap contracts allow two parties to exchange the cash flows and other financial instruments over a certain period of time to generate their profits or cut down their costs.The most common types include interest rate swaps, currency swaps, and commodity swaps. Swaps are used for hedging against changes in interest rates, exchange rates, or commodity prices.

Imagine Company A has a loan with a floating interest rate, making its financial obligations fluctuate with market changes. Company B, on the other hand, has a loan with a fixed interest rate of 6%, ensuring stable interest payments. Both companies are looking to manage their interest rate risks according to their financial strategies and expectations about future rate movements.

Company A is worried about potential increases in interest rates, which would raise its loan costs. On the other hand, Company B anticipates a decline in interest rates and wishes to benefit from lower variable-rate payments to reduce its interest expenses. To align their financial strategies with their market outlooks, Company A and Company B enter into an interest rate swap agreement. In this arrangement, Company A agrees to pay Company B interest based on Company B’s fixed rate of 6%, while Company B agrees to pay Company A interest at the current floating rate.

From the above example swap contracts move allows both companies to better manage their exposure to interest rate fluctuations.

options

Options are similar to futures and forwards but the only difference is that it’s non-binding. Options give the holder the right, but not the obligation, to buy (call options) or sell (put options) an underlying asset at a specified price, known as the strike price, before or at a certain date (Expiry date). Options have different working styles between American and European. An American option is executed at any time before and on the expiry date. Whereas, European options can only be executed on the day of expiration.

Types of option contracts

Call options

Call option gives the investor the right to buy an underlying asset at a predetermined price, known as the strike price, before the option expires. Investors buy call options when they anticipate that the price of the underlying asset will rise above the strike price before the expiration date, aiming to profit from the asset’s price increase.

Put options

A put option gives the investor the right to sell an underlying asset at the strike price before the option expires. Investors purchase put options when they believe the price of the underlying asset will fall below the strike price before the option’s expiration.

In both cases, the investor pays a premium to the option seller for the right conferred by the option.

For example, Investor B expects that the stock of Company ABC, currently trading at $50, is going to decline in the next month. Investor B buys a put option on ABC stock with a strike price of $45, expiring in one month, for a premium of $2 per share. If the price drops below $35 then he can still sell the shares for $45. If the price rises above $45 or does not fall below $43 (strike price – premium paid), exercising the put option would not be profitable. Investor then loses his premium amount($2 per share).