Derivatives are financial contracts whose value is derived from the value of an underlying asset. The underlying asset may be a stock, bond, commodity, currency, interest rate, or market index.
Derivatives are widely used by investors, corporations, and financial institutions for several purposes, including:
- Managing financial risk
- Hedging against price fluctuations
- Speculating on future price movements
- Improving portfolio efficiency
Although derivatives can help reduce risk when used properly, they can also increase risk if used for speculative purposes.
This module introduces the major types of derivative instruments and explains how they are used in financial markets.
9.1 Forward Contracts
A forward contract is a private agreement between two parties to buy or sell an asset at a predetermined price on a future date.
Forward contracts are customized agreements negotiated directly between two parties, usually in over the counter markets.
Key characteristics of forward contracts include:
- privately negotiated contracts
- customized terms
- settlement at a future date
- obligation for both parties to complete the transaction
Example
Suppose a company expects to purchase oil in six months and fears that oil prices may increase. The company can enter a forward contract to lock in a purchase price today.
If oil prices rise, the company benefits because it will still purchase oil at the agreed price.
Forward contracts are commonly used for:
- currency risk management
- commodity price hedging
- interest rate risk management
9.2 Futures Contracts
Futures contracts are similar to forward contracts but are standardized and traded on organized exchanges.
Unlike forwards, futures contracts have standardized terms such as:
- contract size
- expiration date
- settlement procedures
Futures contracts are traded on exchanges such as:
- Chicago Mercantile Exchange
- Intercontinental Exchange
Key features of futures contracts include:
Standardization
Contract terms are standardized to facilitate trading.
Exchange Trading
Futures contracts are traded on organized exchanges.
Daily Settlement
Profits and losses are settled daily through a process called marking to market.
Margin Requirements
Investors must deposit an initial margin to trade futures contracts.
Futures contracts are widely used by investors to hedge price risks or speculate on market movements.
9.3 Options
Options are derivative contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price before or on a certain date.
The price at which the asset can be bought or sold is known as the exercise price or strike price.
Options are divided into two main types.
Call Options
A call option gives the holder the right to buy an underlying asset at the strike price.
Investors buy call options when they expect the price of the underlying asset to increase.
Example
If an investor purchases a call option on a stock with a strike price of 100 and the market price rises to 120, the investor can buy the stock at 100 and potentially profit.
Put Options
A put option gives the holder the right to sell an underlying asset at the strike price.
Investors buy put options when they expect the price of the underlying asset to decrease.
Example
If an investor holds a put option with a strike price of 100 and the market price falls to 80, the investor can sell the asset at 100 and profit from the price decline.
Option Premium
The option premium is the price paid by the buyer to acquire the option contract.
The premium depends on several factors including:
- price of the underlying asset
- time remaining until expiration
- market volatility
- interest rates
9.4 Swaps
A swap is a derivative contract in which two parties exchange financial cash flows based on predetermined conditions.
Swaps are typically used by corporations and financial institutions to manage interest rate or currency risks.
Interest Rate Swaps
An interest rate swap involves exchanging fixed interest payments for floating interest payments.
Example
One company may have a loan with a variable interest rate but prefers fixed payments. Another company may have a fixed rate loan but prefers variable payments.
By entering an interest rate swap, the two parties exchange payment obligations.
This arrangement allows both parties to better manage their interest rate exposure.
Interest rate swaps are commonly used by:
- banks
- corporations
- institutional investors
9.5 Derivative Pricing Basics
Derivative pricing involves determining the fair value of derivative contracts based on the price of the underlying asset and other factors.
Several factors influence derivative prices.
Underlying Asset Price
The price of the underlying asset directly affects the value of the derivative.
For example, if the price of a stock rises, the value of call options on that stock generally increases.
Time to Expiration
The amount of time remaining before a derivative contract expires affects its value.
Longer expiration periods generally increase the value of options because there is more time for favorable price movements.
Volatility
Volatility measures how much the price of an asset fluctuates over time.
Higher volatility increases the value of options because it increases the likelihood of profitable price movements.
Interest Rates
Interest rates can also affect derivative prices.
Changes in interest rates influence the cost of carrying positions and the present value of future cash flows.
Importance of Derivatives in Financial Markets
Derivatives play an important role in modern financial markets because they help participants manage risk and improve market efficiency.
Key benefits include:
Risk Management
Companies and investors can hedge against unfavorable price movements.
Price Discovery
Derivative markets provide information about expected future prices.
Portfolio Management
Investors can use derivatives to adjust portfolio risk exposure.
However, derivatives also carry risks if used improperly, particularly when leverage is involved.