When you plan a vacation, you do not usually wait until you get to your planned destination to book a room. Booking a hotel room in advance provides assurance that a room will be available and locks in the price. Your action reduces uncertainty (risk) for you. It also reduces uncertainty for the hotel. Now imagine that you are a wheat farmer and want to reduce some of the risk of farming. You might presell some of your crop at a fixed price. In fact, contracts to reduce the uncertainty of agricultural products have been traced back to the 16th century.
These contracts on agricultural products may be the oldest form of what are known as derivatives contracts or, simply, derivatives. Derivatives are contracts that derive their value from the performance of an underlying asset, event, or outcome-hence their name. Since the development of derivatives contracts to help reduce risk for farmers, the uses and types of derivatives contracts and the size of the derivatives market have increased significantly. Derivatives are no longer just about reducing risk, but form part of the investment strategies of many fund managers.
1.2 Meaning Of Derivatives
It is a product whose value is derived from the value of one or more basic variables, called bases in a contractual manner. The underlying asset can be equity, forex, commodity, or any other asset.
Thus it is a financial instrument, which derives its value from the underlying asset. e.g. a forward contract on gold, is the derivative instrument, while gold is the actual, underlying asset. The price of the derivative contract will be closely linked to the price & changes in price, of the underlying asset, in this case, gold.
However, the underlying could also be a random event, or a state of nature (like weather). In fact, exotic, complex, hybrid & customized derivatives, while being instrumental in growth & protection, have often had terrible consequences, when unchecked for sense & sensibility.
1.3 Uses Of Derivative Contracts?
Derivatives can be created on any asset, event, or outcome, which is called the underlying. The underlying can be a real asset, such as wheat or gold, or a financial asset, such as the share of a company. The underlying can also be a broad market index, such as the Nifty 50 Index or the BSE Index. The underlying can be an outcome, such as a day with temperatures under or over a specified temperature (also known as heating and cooling days), or an event, such as bankruptcy. Derivatives can be used to manage risks associated with the underlying, but they may also result in increased risk exposure for the other party to the contract.
Let us understand with the story of the wheat farmer. The farmer anticipates having at least 50,000 bushels of wheat available for sale in mid-September, i.e after 6 months. Wheat is currently trading in the market at $9.00 per bushel, which is the spot price. The farmer has no way of knowing what the market price of wheat will be in six months. The farmer finds a cereal producer that needs wheat and is willing to contract to buy 50,000 bushels of wheat at a price of $8.50 per bushel in six months. The contract provides a hedge for both the farmer and the cereal producer. A hedge is an action that reduces uncertainty or risk.
But what if the farmer cannot find someone who actually needs the wheat? The farmer might still find a counterparty that is willing to enter into a contract to buy the wheat in the future at an agreed on price. This counterparty may anticipate being able to sell the wheat at a higher price in the market than the price agreed on with the farmer. This counterparty may be called a speculator. This counterparty is not hedging risk but is instead taking on risk in anticipation of earning a return. But there is no guarantee of a return. Even if the price in the market is lower than the price agreed on with the farmer, the counterparty has to buy the wheat at the agreed on price and then may have to sell it at a loss
Derivatives allow companies and investors to manage future risks related to raw material prices, product prices, interest rates, exchange rates, and even uncontrollable factors, such as weather. They also allow investors to gain exposure to underlying assets while committing much less capital and incurring lower transaction costs than if they had invested directly in the assets.
1.4 Features Of Financial Derivatives
It is a contract: Derivative is defined as the future contract between two parties. It means there must be a contract-binding on the underlying parties and the same to be fulfilled in future. The future period may be short or long depending upon the nature of contract, for example, short term interest rate futures and long term interest rate futures contract.
Derives value from underlying asset: Normally, the derivative instruments have the value which is derived from the values of other underlying assets, such as agricultural commodities, metals, financial assets, intangible assets, etc. Value of derivatives depends upon the value of underlying instrument and which changes as per the changes in the underlying assets, and sometimes, it may be nil or zero. Hence, they are closely related.
Specified obligation: In general, the counter parties have specified obligation under the derivative contract. Obviously, the nature of the obligation would be different as per the type of the instrument of a derivative. For example, the obligation of the counter parties, under the different derivatives, such as forward contract, future contract, option contract and swap contract would be different.
Direct or exchange traded: The derivatives contracts can be undertaken directly between the two parties or through the particular exchange like financial futures contracts. The exchange-traded derivatives are quite liquid and have low transaction costs in comparison to tailor-made contracts. Example of exchange traded derivatives are Dow Jones, S&P 500, Nikki 225, NIFTY option, S&P Junior that are traded on New York Stock Exchange, Tokyo Stock Exchange, National Stock Exchange, Bombay Stock Exchange and so on.
Related to notional amount: In general, the financial derivatives are carried off-balance sheet. The size of the derivative contract depends upon its notional amount. The notional amount is the amount used to calculate the payoff. For instance, in the option contract, the potential loss and potential payoff, both may be different from the value of underlying shares, because the payoff of derivative products differ from the payoff that their notional amount might suggest
1.5 Types Of Derivatives
One form of classification of derivative instruments is between commodity derivatives and financial derivatives. The basic difference between these is the nature of the underlying instrument or asset. In a commodity derivative, the underlying instrument is a commodity which may be wheat, cotton, pepper, sugar, jute, turmeric, corn, soyabeans, crude oil, natural gas, gold, silver, copper and so on. In a financial derivative, the underlying instrument may be treasury bills, stocks, bonds, foreign exchange, stock index, gilt-edged securities, cost of living index, etc. It is to be noted that financial derivative is fairly standard and there are no quality issues whereas in commodity derivative, the quality may be the underlying matter. However, despite the distinction between these two from structure and functioning point of view, both are almost similar in nature.
The most commonly used derivatives contracts are forwards, futures and options.
Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today's pre-agreed price. For example, an Indian car manufacturer buys auto parts from a Japanese car maker with payment of one million yen due in 60 days. The importer in India is short of yen and suppose present price of yen is Rs. 68. Over the next 60 days, yen may rise to Rs. 70. The importer can hedge this exchange risk by negotiating a 60 days forward contract with a bank at a price of Rs. 70. According to forward contract, in 60 days the bank will give the importer one million yen and importer will give the banks 70 million rupees to bank.
Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardised exchange-traded contracts. A speculator expects an increase in price of gold from current future prices of Rs. 9000 per 10 gm. The market lot is 1 kg and he buys one lot of future gold (9000 * 100) Rs. 9,00,000. Assuming that there is 10% margin money requirement and 10% increase occur in price of gold. the value of transaction will also increase i.e. Rs. 9900 per 10 gm and total value will be Rs. 9,90,000. In other words, the speculator earns Rs. 90,000.
Options: Options are of two types- calls and puts. Call options give the buyer the right but not the obligation to buy a given quantity of the underlying asset, 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.
Warrants: Options generally have lives of up to one year, the majority of options traded on options exchanges having maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.
Leaps: The acronym LEAPS means long term equity anticipation securities. These are options having a maturity of upto three years. This option is used as an alternative to buying stocks outright. Using Leaps can result in huge returns, but they can be risky, and you'll have to roll the dice just right. This investment position makes sense if you believe that the stock will be worth much more than the current market price before your options expire.
Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options. They are basically financial instruments whose values are pegged to the performance of a specific basket of stocks. While most options are valued based on an individual stock or financial instrument, basket options are linked to a group of shares. If these underlying stocks rise, the value of the option goes up-it's like owning the shares without actually doing so. One of the basket option characteristics is that basket option is more worthwhile than numerous of fundamental options that is why they are often used in portfolio management. Each basket option might include equity indices, funds, interest rate swap indices, stocks.
Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:
Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency
Currency Swaps: These entail swapping both principal and interest on different currency than those in the opposite direction.
Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaptions is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.
1.6 Functions of Derivatives
Risk aversion tools: One of the most important services provided by the derivatives is to control, avoid, shift and manage efficiently different types of risks through various strategies like hedging, arbitraging, spreading, etc. Derivatives assist the holders to shift or modify suitably the risk characteristics of their portfolios. These are specifically useful in highly volatile financial market conditions like erratic trading, highly flexible interest rates, volatile exchange rates and monetary chaos.
Prediction of future prices: Derivatives serve as barometers of the future trends in prices which result in the discovery of new prices both on the spot and futures markets. Further, they help in disseminating different information regarding the futures markets trading of various commodities and securities to the society which enable to discover or form suitable or correct or true equilibrium prices in the markets. As a result, they assist in appropriate and superior allocation of resources in the society.
Enhance liquidity: As we see that in derivatives trading no immediate full amount of the transaction is required since most of them are based on margin trading. As a result, large number of traders, speculators arbitrageurs operate in such markets. So, derivatives trading enhance liquidity and reduce transaction costs in the markets for underlying assets.
Catalyse growth of financial markets: The derivatives trading encourage the competitive trading in the markets, different risk taking preference of the market operators like speculators, hedgers, traders, arbitrageurs, etc. resulting in increase in trading volume in the country.
Brings perfection in market: Lastly, it is observed that derivatives trading develop the market towards 'complete markets'. Complete market concept refers to that situation where no particular investors can be better off than others, or patterns of returns of all additional securities are spanned by the already existing securities in it, or there is no further scope of additional security.