Basics of Derivatives

In the realm of finance, a derivative is a contract between two or more parties where the value is based on the performance of an underlying entity. This entity can be a security or a set of assets, such as an index.

Key Points:

• A derivative is a contract whose value is based on an underlying financial asset, security, or index.
• Derivatives can be used for risk management (hedging) or assuming risks for potential returns (speculation).
• Common types of derivatives include futures contracts, forward contracts, swaps, warrants, and options.

Importance in Banking and Finance Exams:

Understanding the basics of derivatives is crucial for banking and finance competitive exams. This article provides updated and relevant information on derivatives, including their meaning, uses, types, advantages, and more.

Knowing Derivatives

Derivatives are essentially ‘secondary securities’ whose value is directly derived from the value of the primary security they are linked to.

Derivatives

Derivatives are advanced investing instruments whose value is based on an underlying asset, such as a stock, bond, commodity, or currency. However, owning a derivative does not mean owning the underlying asset itself.

Commonly Used Derivatives

• Forward contracts: Customized contracts between two parties to buy or sell an asset at a specified price on a future date.

• Futures contracts: Standardized contracts traded on exchanges to buy or sell an asset at a specified price on a future date.

• Warrants: Certificates issued by a company that give the holder the right to buy a certain number of shares of the company’s stock at a specified price within a specified time period.

• Options: Contracts that give the holder the right, but not the obligation, to buy or sell an asset at a specified price within a specified time period.

• Swaps: Agreements between two parties to exchange cash flows based on a specified interest rate or other financial variable.

Applications of Derivatives

Derivatives are used for various purposes, including:

• Hedging: To reduce the risk of price fluctuations in the underlying asset.

• Speculation: To profit from price movements in the underlying asset.

• Arbitrage: To take advantage of price discrepancies between different markets.

• Income generation: To generate income by selling options or entering into swap agreements.

Types of Derivatives

Forwards

• Holder is charged to perform the contract.
• Forwards are not traded on stock exchanges.
• They are available over-the-counter (OTC) and are not marked-to-market.
• Forwards can be customized as per the requirements of the parties involved.

Futures

• They are standardized contracts that allow the holder to buy and/ or sell the asset at an agreed price at the specified date.
• The parties are under an obligation to perform the contract. These contracts can be traded on the stock exchange.
• The value of such future contracts is marked to the market every day.

Options

• They are contracts that give the buyer a right to buy and/ or sell the underlying asset at the specified price during a particular period of time.
• The buyer is not under any obligation to perform the option.
• The seller is known as the ‘option writer’ and the specified price is called the strike price.

Swaps

• Two parties exchange their financial obligations under this contract.
• Cash flows are based on a principal amount agreed by both the parties without exchanging the principal. The amount is based on a rate of interest.
• While one cash flow remains fixed, the other changes based on the benchmark rate of interest.
• Swaps are OTC contracts between businesses and/ or financial institutions and are not traded on stock exchanges.

Derivative Concepts

• Generating option ability
• Avoiding payment of taxes
• Providing leverage facilities
• Hedging or alleviating risks in the underlying
• Obtaining exposure for the underlying assets
• Switching asset allocations between different asset classes
• Speculation and generating profits

Underlying in Derivatives

Underlying refers to the security that must be delivered when a derivative contract is exercised. The most widely accepted underlying in derivatives are:

• Stocks/ Shares/ Equity: An indivisible unit of capital expressing ownership between the shareholder and the company.
• Currency: A medium of exchange for goods and/or services, usually issued by the government and accepted at face value.
• Commodity: A basic interchangeable good that can be used with other goods of the same type.
• Interest Rate: The amount of interest due per period, as a percentage of the lent, deposited, or borrowed amount.

Participants of the Derivatives Market

The following are the different types of participants in the derivatives market:

• Hedgers: Use derivatives to reduce risk.
• Speculators: Use derivatives to profit from price movements.
• Arbitrageurs: Use derivatives to profit from price discrepancies between different markets.
• Market makers: Provide liquidity to the market by buying and selling derivatives.
• Clearinghouses: Ensure the smooth functioning of the market by guaranteeing the settlement of trades.

Advantages of Derivatives

In addition to profit-making, derivatives offer several advantages:

Non-binding Contracts

• Derivative contracts give investors the right to perform an investment, but there is no obligation to do so.
• This flexibility allows investors to adjust their investment strategies as needed.

Leverage Returns

• Derivatives enable investors to achieve significant returns that may not be possible with primary investment instruments like stocks and bonds.
• Unlike stocks, derivative markets can offer the potential to double investments in a shorter time frame.

Advanced Investment Strategies

Financial engineering, a field centered around the derivatives market, empowers investors to construct intricate investment strategies that work to their advantage.

Disadvantages of Derivatives

Despite its potential, the derivatives market also carries certain drawbacks:

1. Overpriced Options:

• Derivatives, being derived from other securities, pose valuation challenges.
• The derivatives market lacks the liquidity of the stock market, resulting in fewer “players” and increased bidding, which drives up prices.

2. Time Restrictions:

• Derivatives carry a significant risk due to their specified contract life.
• Once the contract expires, it becomes worthless, posing a time-sensitive challenge for investors.

3. Complexity:

• Many investors are unaware of the complexities of the derivatives market.
• This vulnerability is exploited by scam actors who use derivatives to create enticing schemes that target both professional and non-professional investors.

4. Legalized Gambling:

• Critics argue that derivatives trading in financial markets resembles legalized gambling.
• The nature of derivatives trading is akin to other forms of gambling activities.