Introduction to Derivatives

What are Derivatives?

It is financial contract whose price depends on the underlying asset or a group of assets. The underlying asset can be stocks, bonds, commodities, currencies or interest rates; they are traded either on exchange or over the counter (OTC). For example, if you are in the United States but want to invest in a British company by buying shares from the London Stock Exchange in British Pound, you are prone to exchange rate risk.

To explain this, let us suppose you want to sell British stock and reap the profits, meanwhile the US Dollar rate increases with respect to British Pound. Now, the profit that you get after selling the British Stock will be in British Pound and when you try to convert it to US Dollars it will decrease as the price of the US Dollar has increased. Had the exchange rate been locked down, your profit would have been more. This “locked down” can take place by buying currency derivatives.

Most common types of Derivatives:

Futures:

This is an agreement between parties to buy or sell an asset at a certain time in the future and at a certain price.

Let’s say there is a Christmas sale on the Xbox where it’s been sold for $300 instead of $600 and you want to buy the Xbox. The problem here is that you don’t have enough money to currently purchase the Xbox, but you do not want to miss out on the opportunity. If there is a way that you can buy the Xbox at the same discounted rate even after a few months, then this would be great. This contract of getting the Xbox at the discounted price after a few months is called Futures Contract. As you can see here the price is dependent on the underlying asset (Xbox) hence it is a form of derivative.

Each futures contract has got a specific lot size. You cannot buy a futures contract involving 1 share of company ABC. If ABC’s lot size is 100 that means 1 futures contract of company ABC is equivalent of buying 100 shares of ABC. The best part, is you do not have to pay the price of all the shares.

Let us say there is a futures contract between you and the oil company, and the agreed price is $10/barrel, and the lot size is 200 barrels. For example, say the futures contracts for oil increases to $15/barrel the day after you and the oil company enters the futures contract at $10/barrel. The oil company has lost $5/barrel because the selling price just increased from the price at which they were obligated to sell the oil. You are profited by $5/barrel because the price you are obligated to pay is less than what the rest of the market is obliged to pay in the future for oil. So, on that day, $1,000 ((15–10) x 200) is debited from the oil company’s account and $1,000 is credited to your account. These kinds of adjustments are done occur on a daily basis, as the market moves, depending on the closing price of oil each day.

Unlike the stock market, futures positions are settled daily, which means that gains and losses from the days’ trading are deducted or credited to your account each day at the end of the trading session. In the stock market, the gains (or losses) from movements in price are not realized until you sell the stock. When either party decides to close out their futures position, the contract will be settled. If the contract were settled at $15/barrel, the oil company would lose $1,000 on the futures contract and you would have made $1,000 on the contract.

Forwards:

Forwards are like Futures with the only difference being that they are not traded on an exchange but are traded on over-the-counter markets. So, as there is no central exchange to keep track of what goes where and the terms are not regularised, you can change the lot size and the settlement process for the derivative. It also involves counterparty risk which means that it is possible that either the buyer or the seller in the contract is not able to meet financial needs or basically does not have money to pay back. This can arise because the buyer or seller are not placed under any regulations and sometimes either party can sell the contract to another party causing expanded involvement. Put simply, consider you and the oil company have a contract and the oil company decide to sell the contract to company ABC. This now means the contract lies between you and the ABC; this increases the counterparty risk.

Swap:

Swap is precisely what the word means. Let us say there are two businessmen Daniel and Joe. They both have 5 PlayStations and 5 Xboxes. But Daniel wants to make business in PlayStation and Joe wants to make business in Xbox. Assume that they cannot trade directly with each other. So, they go to a SWAP Bank taking HSBC as an example. HSBC tells Daniel to give them all of his Xboxes, it then keeps one itself and gives the rest to Joe while HSBC asks Joe to give all his PlayStations and keeps for itself and gives rest to Daniel. Now Daniel has 9 PlayStations and Joe has 9 Xboxes and HSBC has 1 Xbox and 1 PlayStation. Therefore, HSBC receive a profit for initiating the swap.

In more real terms, let us say Daniel is in UK and Joe is in US. Daniel goes to a bank in UK asking for a loan for his business and the bank says we offer Fixed Rate of 6% and Floating rate of LIBOR+3%. Joe goes to a bank in US asking for a loan for his business and the bank says we offer Fixed Rate of 8% and Floating rate of LIBOR+1%.

Daniel has the requirement of Floating Rate and Joe has the requirement of Fixed Rate. So, HSBC tells Daniel to buy Fixed Rate. In return, he will get a Floating rate of LIBOR+2%. HSBC tells Joe to buy Floating rate and in return he will get a Fixed rate of 7%. So here, what HSBC do is called swapping, it swaps the Floating rate from US to UK and Fixed Rate from UK to US.

Swaps related to the cash flows and potential defaults of mortgage bonds are an extremely popular kind of derivative.

Options:

What if I tell you that the stock price of Apple will be rising from $148 to $160 in the next 20 days. You would love to buy the stocks now for $148 and sell once it hits $160. But who am I to predict the future? You, considering me your best friend and the friend who knows about Apple, want to trust me on my news and not miss out on the opportunity but also beware of false news. In such a situation, you can buy a Call Option. Before jumping into what a call option is, let us see what an option means.

Options can be divided into 2 categories: Call and Put.

Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset (stock), at a given price on or before a given future date.

Puts give the buyer the right but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Even options have lot size which was discussed in the Futures post. So, when you say that you buy one option of Apple, it means you buy 100 shares of Apple where 100 is the lot size.

When one thinks that the stock price is going to rise (bullish), they buy a call option. When one thinks that the stock price is going to fall (bearish), they buy a put option.

Let us say you think that the price of Apple will rise from $148 to $160 which means you are bullish. So, you go to the market on 1st January and buy 1 Call Option for Apple which says that you can buy 100 shares of Apple at $148 each, the cost of the option is $75, and you have to use the option before 30th January. Here, 100 is the Lot Size, $148 is the Strike/Exercise Price, $75 is called the Premium which the buyer must pay, and 30th January is the Expiry Date.

Now if the stock price of Apple rises to let’s say $155 before 30th January then you can exercise your Call Option and buy 100 shares of Apple at $148 (Strike Price) and sell the shares at $155 (Current Price) giving you a profit of $700 ((155–148) x 100) but remember you also need to pay the premium to the seller. The formula of options is complex, so it takes in time factor and other factors to calculate the premium rise that comes with price rise.

So, the net profit is the Strike Price - (Current Price + Premium Paid). This is then multiplied by 100 (if each contract is 100 shares) and the number of contracts bought.

Like Call Options, if you think that the price of the stock will go down, then you buy a Put Option. Let us say you think that the price of Apple will decline from $148 to $130 which means you are bearish. So, you go to the market on 1st January and buy 1 Put Option for Apple which says that you can sell 100 shares of Apple at $148 each, the cost of the option is $75, and you have to use the option before 30th January. Now if the stock price of Apple declines to let's say $135 before 30th January then you can exercise your Put Option and sell 100 shares of Apple at $148 (Strike Price) giving you a profit of $1,300 ((148–135) x 100).

The difference between buying options and futures is that in case of options, the loss is limited, and profits are unlimited while in the case of futures, the loss, and profits, both are unlimited.

In options, the loss is limited to the amount of premium paid. For example, if we have paid a premium of $5/share for a lot of 100 shares, then the premium paid is $500 (5 x 100). If the share price declines let us say by $20 then you will not be exercising your option because you were expecting it to rise. Hence, if you do not exercise the option, the maximum you will lose is your premium which is $500. If you bought futures of the same company and the price declines by $20, then you could lose $2000 (20 x 100). As you can see, the loss in futures in unlimited but in options, it is limited to the premium paid.

Conclusion:

Although derivatives initially seem very complex, if you are able to understand them and master them then you are in a position to make significantly increased returns. In order to use these derivatives contacts you should wait until you are confident with the risks associated with them as they can be very dangerous if used in the wrong way.