Derivatives are often considered complex financial tools. However, they are vital in modern finance. Derivatives obtain their worth from the underlying assets, such as stocks, bonds, commodities, or currencies.
They offer a range of benefits, including risk management, speculation, and arbitrage opportunities. By understanding the various types of derivatives and their underlying principles, individuals and businesses can make informed decisions and deal with the complex challenges of the financial world. Let us learn more.
What is a Derivative?
So, what is a derivative? At their core, financial derivatives are agreements between two parties that involve the exchange of a specific asset or cash flow at a predetermined future date. This exchange is contingent upon the price or value of an underlying asset. Common types of derivatives include futures, options, swaps, and forwards.
The Importance of Derivatives
The financial markets rely heavily on derivatives, serving multiple roles for their participants. Various types of derivatives are used for risk management. Enterprises and individuals use different derivatives to protect themselves against losses caused by unfavourable price changes. For instance, a corporation that fears increased raw material prices may sign an agreement to purchase them at a set price in the future, thereby preserving its profit margins.
Derivatives can also be used for speculation. Speculations can be made on the future movement of prices of the underlying assets. Speculators can make money or lose it, depending on the accuracy of their predictions.
Besides speculation and risk management, arbitrage also relies heavily on derivatives. In arbitrage, one seeks to make riskless profits with price differences between multiple markets. Such instances can be identified and exploited using various derivatives. Take the case of a stock being priced differently on two different exchanges. Arbitrageurs can use derivatives to profit from the differences in these situations.
What is a Futures Contract?
A futures contract is an agreement between two parties to purchase or transfer a particular asset at a specific price for a later date. In contrast to an options contract, which gives the buyer an entitlement but not a duty to trade them, these derivatives are compulsorily imposed on both parties. This standardisation ensures there is enough liquidity and improves the efficiency of trading.
The components of futures contracts comprise (among others) underlying assets, contract size, month of delivery, tick size, and margin requirements. The underlying asset may include a commodity, currency, or stock index (as well as an interest rate). The contract size defines the volume of the underlying asset to be delivered. The delivery month indicates when the contract will expire and physical delivery will occur. A minimum price increase per contract is known as tick size, while margin requirements refer to money traders depositing with their brokers to guarantee the contract.
Uses of Futures for Risk Management and Speculation
Futures contracts play a crucial role in financial markets, particularly in hedging. These contracts offer a way to protect against potential losses that result from adverse price movements in an underlying asset.
Futures contracts also create opportunities for speculation. These contracts allow speculators to take advantage of expected future price changes in the underlying assets. If their predictions are accurate, they stand to profit from any price changes. Conversely, incorrect predictions could lead to significant financial losses.
In addition to hedging and speculation, futures contracts play a significant role in price discovery. The future market values of the commodity can often be inferred from the price trends of future contracts. This information is essential for business people, investors, and decision-makers.
What is an Options Contract?
An options contract is a flexible financial instrument that allows traders to buy or sell an underlying asset at a predetermined price within a specified time. These types of derivatives are valuable for managing risk and implementing speculative strategies because of their versatility.
Call and Put Options
An options contract can be classified into two main categories: call options and put options. A call option gives the buyer the right to acquire an underlying asset for a particular price, also known as the strike price, before its expiration date. It is advantageous for traders who predict an increase in the prices of the underlying assets. Conversely, a put option gives the buyer the right to sell an underlying asset for a particular price (strike price) before its expiration date; this is advantageous when a trader anticipates falling prices.
Option Pricing and the Black-Scholes Model
The Black-Scholes model is a widely used mathematical formula for calculating the value of options. This particular model accounts for several determinants, such as the price of the underlying asset, the strike price, the period until expiration, the risk-free interest rate, and the expected volatility (implied). Implied volatility determines anticipated price changes and can influence option pricing greatly.
The Black-Scholes formula (being a financial derivative formula) has certain limitations. For instance, it assumes that markets are simple, but real-life market conditions tend to be complex, and there are other pricing models, like the binomial option pricing model, which can be used in different scenarios.
Option Volatility and Option Prices
The primary factor influencing option prices is volatility, which refers to the extent of price fluctuations. Consequently, options become more costly when volatility is higher due to the greater likelihood of substantial price movements. Conversely, options are more affordable during periods of low volatility.
Volatility indices, such as the VIX from the Chicago Board Options Exchange (CBOE), are used to gauge market-implied volatility. These indices allow traders to evaluate market sentiment and adjust their option strategies accordingly.
The World of Swaps
Cash flows are exchanged between two parties based on a pre-arranged schedule through swaps, a versatile financial instrument. The exchange can either be based on assets such as currencies or interest rates. These types of derivatives are mostly used to manage risk, enhance financial efficiency, and facilitate transactions that would have otherwise been difficult or costly.
Interest Rate Swaps
Interest rate swaps are agreements between two parties to exchange interest payments on a theoretical amount. Such swaps can either be fixed for floating or float for floating.
In fixed-for-floating swaps, some parties receive fixed interest rates while others receive floating rates, typically based on benchmarks such as LIBOR. Businesses and financial institutions commonly utilise this swap as a hedge against interest rate risks. For example, if a company is concerned about rising interest rates, it can opt for a fixed-for-floating swap to secure a steady interest rate for its borrowings.
Floating-for-floating swaps entail the exchange of two floating interest rates—such swaps aid in managing the disparities between different benchmarks related to the costs of borrowed funds.
Currency Swaps
Currency swaps are contracts where two parties transfer principal amounts in different currencies. These swaps act as foreign exchange risk mitigation tools. For example, if a company has liabilities denominated in another currency, it may engage in a financial arrangement called a currency swap. Through this mechanism, it changes its foreign liabilities into domestic ones.
A foreign currency swap is one of the ways to obtain financial support in another country at lower rates. For example, a company may choose to convert its domestic debts into foreign currency debts, thus taking advantage of the low lending rates available in the foreign money markets.
Credit Default Swaps (CDS)
CDS, or credit default swaps, are insurance contracts designed to protect the buyer if a specific debt instrument defaults. If issuers default on their payments, the face values of the debt instruments are paid to the buyers.
Before the 2008 financial crisis, CDS were widely utilised in financial markets. The banks had significant joint holdings of CDS, and hence a single bank would affect other banks when it failed, leading to instability as each bank was forced to call on its note-issuing ability.
Other Types of Swaps
Interest rate, currency, and credit default swaps are other swap types accessible on the market. The equity swap involves exchanging cash flows according to how well two different equity indices perform relative to one another. Commodity swaps are utilised to manage risks related to the prices of various commodities.
Exotic Derivatives
A derivative is exotic when it has features different from those of regular options or futures contracts. Exotic derivatives are made to meet specific needs and risk profiles, giving rise to their unique characteristics and payoffs. These derivatives can offer valuable risk management and speculation opportunities, even though they can be complicated.
Asian Options
Asian options, also known as average price options, are based on the average price of an underlying asset over a given period, making it less subject to fluctuations in short-term prices. The final payment, therefore, relies on the mean value instead of its expiration price.
There exist two principal types of Asian options: arithmetic averages and geometric averages. Arithmetic average options compute the daily prices’ sum over a specified number of days and then divide this sum by that particular number of days, while geometrically averaged ones calculate the average by multiplying daily prices together and then taking the nth root, where n represents the total number of days involved.
Barrier Options
Based on reaching a certain price level, known as the barrier, barrier options can be activated or deactivated. Paying out or becoming worthless is what happens when the barrier is breached.
There are several types of barrier options, including knock-in options, knock-out options, up-and-out options, down-and-in options, and their combinations. The knock-in option becomes effective when you breach the barrier, while the knock-out option becomes useless when you breach the barrier. Up-and-out and down-and-in options are specific varieties of knock-out and knock-in options that are turned on or off depending on how the barrier is broken.
Lookback Options
The ability to buy or sell the underlying securities at the highest or lowest price they have ever been makes lookback options very appealing. That is how this quality serves as a protection against unfavourable price movements.
For one, there are fixed-strike and floating-strike lookback choices, which are two lookback option types commonly found in today’s market, where fixed-strike lookback options incorporate previously set strike prices, whereas, in floating-strike lookback choices, buyers select their own based on best-to-worst price during option lifetime.
Wrapping Up
Derivatives are complex financial instruments that offer a range of benefits and risks. They are essential tools for risk management, speculation, and arbitrage opportunities.By understanding the various types of derivatives, their principles, and the associated risks, we can make informed decisions, minimise losses, and make gains in the financial markets. If you wish to learn about all the essential financial instruments, you can enrol in Imarticus Learning’s Certified Investment Banking Operations Professional programme. This is one of the top investment banking courses out there that will prepare you for success in the financial domain.
