Derivatives are financial instruments that derive their value from underlying assets. They come in four main types: forwards, futures, options, and swaps. Each type has unique characteristics, allowing investors to hedge risks, speculate on price movements, or engage in arbitrage opportunities.

Understanding derivatives is crucial for managing financial risks and enhancing investment strategies. While they offer benefits like customization and leverage, derivatives also carry risks such as counterparty default and complex pricing. Mastering these instruments can provide valuable tools for financial management.

Types of Derivatives

Types of derivative contracts

• Forwards
  • Customized contract between two parties to buy or sell an asset at a specified future date and price agreed upon today
  • Traded over-the-counter (OTC) directly between counterparties without going through an exchange
  • No standardization in contract terms such as size, expiration date, or underlying asset
  • Higher counterparty risk since there is no clearing house to guarantee the transaction
• Futures
  • Standardized contract to buy or sell an asset at a predetermined future date and price
  • Traded on organized exchanges like the Chicago Mercantile Exchange (CME) or Intercontinental Exchange (ICE)
  • Highly regulated and transparent with standardized contract terms and public pricing
  • Lower counterparty risk due to the presence of clearing houses that act as intermediaries
• Options
  • Contract giving the holder the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a specified price (strike price) on or before a certain date (expiration date)
  • Traded on exchanges like the Chicago Board Options Exchange (CBOE) or OTC
  • Buyer pays a premium to the seller upfront for this right, which is the maximum potential loss for the buyer
• Swaps
  • Agreement between two parties to exchange cash flows or liabilities from two different financial instruments over a specified period
  • Typically involve exchanging a fixed rate for a floating rate (interest rate swap), or cash flows in different currencies (currency swap)
  • Traded OTC and customized to suit the needs of the counterparties
  • Used to hedge interest rate risk, currency risk, or other types of financial risk

Characteristics of derivative types

• Forwards
  • Binding contract with terms tailored to the specific needs of the parties involved
  • No upfront payment required, with the entire transaction settling at the end of the contract
  • Physical delivery of the underlying asset or cash settlement are both possible
  • Expose parties to counterparty risk, as there is no clearing house to guarantee the transaction
• Futures
  • Binding contract with standardized terms such as contract size, expiration dates, and minimum price fluctuations (tick size)
  • Requires an initial margin payment and daily marking-to-market to settle gains or losses
  • Settled daily until the end of the contract, with final settlement on the expiration date
  • Usually cash-settled, but physical delivery is possible for some contracts like commodities
• Options
  • Non-binding for the buyer, who has the right but not the obligation to exercise; binding for the seller if the buyer exercises
  • Call options give the right to buy the underlying asset, while put options give the right to sell
  • Buyer pays a premium upfront, which is the maximum potential loss; no further payments required
  • American options can be exercised anytime before expiration, while European options can only be exercised at expiration
• Swaps
  • Parties agree to exchange cash flows at specified intervals (quarterly, semi-annually, or annually)
  • No upfront payment required, but sometimes a small fee is paid to compensate for differences in the value of the cash flows
  • Settled periodically over the life of the contract, which can range from a few months to several years
  • Notional principal is not exchanged; only the cash flows based on the principal are exchanged

Applications of derivatives

• Hedging
  • Derivatives can be used to reduce exposure to various financial risks, such as price fluctuations (commodity prices), interest rate changes, or currency movements
  • Example: A company can use currency forwards to lock in an exchange rate for future foreign currency transactions (accounts payable or receivable), minimizing currency risk
• Speculation
  • Derivatives allow traders to take positions on the future direction of market prices without actually owning the underlying asset
  • Speculators aim to profit from price movements by buying derivatives they believe are undervalued or selling those they believe are overvalued
  • Example: A trader can buy call options on a stock, expecting the price to rise and profiting from the increased value of the options
• Arbitrage
  • Derivatives can be used to exploit price discrepancies in different markets or between related assets
  • Arbitrageurs aim to profit from these discrepancies while taking minimal risk by simultaneously buying and selling the mispriced assets
  • Example: If the price of a stock futures contract diverges from the underlying stock price, an arbitrageur can buy the cheaper asset and sell the more expensive one, profiting from the price difference

Advantages vs disadvantages of derivatives

• Forwards
  • Advantages: Customizable terms to suit specific needs, no upfront costs, can be used for hedging or speculation
  • Disadvantages: Counterparty risk, lack of liquidity due to OTC nature, no price transparency
• Futures
  • Advantages: Standardized contracts leading to high liquidity, price transparency, lower counterparty risk due to clearing houses
  • Disadvantages: Requires initial margin and daily mark-to-market settlements, limited customization
• Options
  • Advantages: Flexibility (right, but not obligation to exercise), limited downside risk for buyers, can be used for hedging, speculation, or income generation (selling options)
  • Disadvantages: Upfront premium cost, time decay of option value (theta), complex pricing models (Black-Scholes)
• Swaps
  • Advantages: Can be used to manage interest rate or currency risk, no upfront costs, customizable terms to match cash flows
  • Disadvantages: Counterparty risk, lack of liquidity due to OTC nature, complex valuation and documentation requirements