What is a Derivative? What are the different types of derivatives?

 What is a Derivative?

➤ Derivative is a contract between two person to buy or sell a certain asset at a future date at a price fixed today.

Example:- Suppose Mr. A & Mr. B enters into a contract on a stock of Apple at a price of $2400 for 50 shares 6 month from now. Mr. A (buyer) is Long & Mr. B (seller) is Short.

Q1. What amount will Mr. A pay to Mr. B or, Mr. B will pay to Mr. A today?

Ans:- Nothing. Because it is only a contract.

Q2. On maturity (i.e. end of 6th month) the price of Apple share happen to be $2440.

• Who wins the bet?
• Ans:- Mr. A. Because result of contract is in his favor.

Mr. A will take delivery of 50 shares from Mr. B at the rate of $2400, that is by paying 2400×50 = $120,000.

Q3. if this contract is cash settled (i.e. Non- deliverable), how settlement will take place?

Ans:- Mr. B will pay the difference to Mr. A 40×50 = $2000.

➤ Derivative is a financial contract which derive its value from some underlying assets. 

The underlying may be:-

• a Stock (e.g. stock of Amazon or Tata etc.).
• an Interest rate (e.g. LIBOR).
• Commodity (e.g. Gold).
• Currency (e.g. Rupees per dollar).
• Stock market index (e.g. S&P500, NIFTY, SENSEX etc.).
• Energy.
• Temperature.
• Rainfall.
• etc.

➤ Derivatives are used for risk management, it transfers the risk from one party to another. but now days it is looked upon as a contract design for betting or gambling or for speculation.

➤ The buyer, who purchases the Derivative, is referred as Long and the seller is referred as Short. 

➤ Derivative can be used to create strategies that cannot be implemented with the underlyings alone. 

What are the structure of Derivative markets?

As you likely know, Equity shares trade on organized stock exchanges (like; NYSE, BSE, NSE etc.) as well as in over-the-counter (OTC) markets. similarly the derivative world also comprises organized Exchanges and OTC markets.

♦ Exchange Traded Derivative :-

• Flow of money is a critical element of derivatives trading. there would be no confidence in markets in which money is not efficiently collected and disbursed. Derivative Exchanges have done an excellent job of Clearing and Settlement, derivative exchanges clear and settle all contracts overnight, whereas most securities exchanges require two business days.

• Exchange traded derivatives are standardized. it means that its terms and conditions are precisely specified by the exchange and there is very limited ability to alter those terms. (for example:- certain types of derivatives that expire only on the third Friday of march, June, September, December. if a party wanted the derivative to expire on any other day, it would not be able to trade such a derivative on that exchange).

• The clearinghouse is able to provide Credit guarantee by requiring a cash deposit, usually called Margin Deposit from the participants to the contract. So virtually No counter party default risk.

• Higley Regulated because exchange markets are said to have transparency, which means that full information on all transactions is disclosed to exchange and regulatory bodies (such as SEC in USA, SEBI in India etc.).

• Most contracts are Squired-off prior to maturity and those that are not squired-off are generally subject to Cash settlement (Non- deliverable).

TYPES OF EXCHANGE TRADED DERIVATIVE CONTRACTS:-

• Futures Contract.
• Options Contract.

♦ Over-the-counter (OTC) Derivatives:-

OTC derivative markets are an informal network of market participants that are willing to create and trade virtually any type of derivative that can be legally exist.

The backbone of OTC markets is the set of Dealers, which are typically BANKs. 

• These dealers informally agree to buy and sell various derivatives, it is informal because the dealers are not obligated to do so. their participation is based on a desire to profit, which they do by purchasing at one price and selling at a higher price. 

(Most of these banks are members of a group called the International Swap and Derivatives Association (ISDA). it is a worldwide organization of financial institution that engage in derivative transactions, primarily as dealers.)

• OTC derivatives are customized. it means that its terms and conditions can alter according to your choice. 
• OTC derivative markets operate at a lower degree of regulation.
• OTC markets retain a degree of privacy with lower transparency and most importantly, the OTC markets will remain more flexible than Exchange traded derivative.
• Most contract are Physically settled on maturity.  
• Counter party default risk exist. 

TYPE OF OTC DERIVATIVE CONTRACTS:-

• Forward Contract.

• SWAP Contract.

What is Forward Contract, Futures Contract, Options and Swap?

➧Forward Contract:-

➣A forward contract is an Over-the-counter contract in which two parties agree that one party will purchase an underlying asset from other party at a future date, at a price fixed today.  

➣As mentioned earlier the contract is customized, hence the size of the contract depend on the term of the contract.

➣A forward contract is a commitment. each party agrees that it will fulfill its responsibility at the designated future date. Failure to do so constitutes a default and the non- defaulting party can initiate legal proceedings to enforce performance.

➧Futures Contract:-

➣A futures contracts are specialized versions of forward contracts.

➣ It is a standardized derivative contract created and traded on exchange, in which two parties agree that one party (the buyer) will purchase an underlying asset from other party (the seller) at a later date and at a price agreed on by the two party when the contract is initiated. 

➣The most important distinctive characteristic of futures contracts is the daily settlement of gains and losses and the associated credit guarantee provided by the exchange through its clearing house.

Both Forward contract and Futures contract comes under Forward Commitment, it means Payoff will definitely occur and both party have a Right as well as Obligation.

➧Options :-

➣An option is a contingent claim, it means Payoff may or may not occur and one party have right and other party have obligation.

➣An option is a derivative contract in which one party (the buyer) pays a sum of money to other party (the seller) and receives the right to either buy (C+) or sell (C-) an underlying asset at a price fixed today on a specific expiration date or at any time prior to the expiration date.

➣Option Buyer (C+) If the price moves in their favor, the option is realized and they will get the difference otherwise the derivative lapse and they will not have to pay the difference.

➣For option buyer (C+) It is like a lottery ticket, which will pay the difference on the upside but lapse on the down-side.

➣Options are generally of two types:-

• Call Option :- For Upside betting.
• Put Option:- For Downside betting.

Example:- Mr. A is bullish on a stock which is presently trading at $490.

⋕Alternative 1 :- He may Buy the stock, this requires 2 things:-1st Funds and 2nd Risk tolerance level.

⋕Alternative 2:- He may Buy a Forward contract or a Futures Contract on the stock, Nothing needs to paid now but risk tolerance is required, because when share price will go down he will have to pay the difference.

⋕Alternative 3:- He may buy a Call Option (C+). this is like buying a lottery ticket. if on maturity share price will rise above $490, he will get the difference amount and if share price will go bellow $490 than call lapse and he will have to pay Zero.

➧SWAP Contract :-

it is an Over-the-counter derivative contract in which two parties agree to exchange a series of cashflow whereby one party pays a variable series that will be determined by an underlying asset or rate and the other party pays either:-

(1) a variable series determined by a different underlying asset or, rate. or,

(2) a fixed series.

Types of SWAPs :-

• Financial swap.
• Currency swap.
• Commodity swap, etc.

How do derivatives contribute to an economy?

• They have higher liquidity.
• They have lower transaction cost.
• As a result of 1st two bullets, Trading is easier in derivative, New information get reflected in market price more quickly. This means Derivative helps to make the market informationally efficient and promote price discovery.
• Trading in derivative is so easy and frictionless, any arbitrage opportunity (Mispricing) is exploited immediately.
• Lower capital requirement.
• Easy to go short via derivative as compare to shorting in cash market.
• Derivative enable risk management, that is transfer of risk from Hedger to Speculator.

What are the controversies related to derivative market?

1st Allegation :- Derivative provide excessive leverage, This can result in increasing default by Speculators and creditors.

Defence:- Regulation in the form of Margin requirement, Mark-to-market features, etc. should be tightened. 

2nd Allegation :- Derivatives are complexed, Small investor may burn their hand.

Defence :- Educate them.

3rd Allegation :- Derivatives are responsible for The South-East-Asian Crisis, Credit Crisis etc.

Defence:- Crisis used to occur even when derivatives were not there.

 Conclusion:- DO NOT BLAME THE GUN, BLAME THE SHOOTER. 

Thank you.. Stay happy 😊 and Safe....