DerivativesDerivativesDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. are financial instruments like equity and bonds, in the form of a contract that derives its value from the performance and price movement of the underlying entity. This underlying entity could be anything like an asset, index, commodities, currency, or interest rate—each example of the derivative states the topic, the relevant reasons, and additional comments as needed.
The following are the most common example –
- OptionsOptionsOptions are financial contracts which allow the buyer a right, but not an obligation to execute the contract. The right is to buy or sell an asset on a specific date at a specific price which is predetermined at the contract date.
- SwapsSwapsSwaps in finance involve a contract between two or more parties that involves exchanging cash flows based on a predetermined notional principal amount, including interest rate swaps, the exchange of floating rate interest with a fixed rate of interest.
Most Common Examples of Derivatives
Example #1 – Forwards
Let us assume that corn flakes are manufactured by ABC Inc for which the company needs to purchase corn at a price of $10 per quintal from the supplier of corns named Bruce Corns. By making a purchase at $10, ABC Inc is making the required margin. However, there is a possibility of heavy rainfall, which may destroy the crops planted by Bruce Corns and, in turn, increase the prices of corn in the market, which will affect the profit marginsProfit MarginsProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. of ABC. However, Bruce Corns have made all the possible provisions to save the crops and have this year used better farming equipment for the corns, therefore, expects higher than the normal growth of the corns, without any damage by the rains.
Therefore, the two parties come to an agreement for six months to fix the price of corn per quintal at $10. Even if the rainfall destroys the crops and the prices increase, ABC would be paying only $10 per quintal, and Bruce Corns is also obligated to follow the same terms.
However, if the price of the corn falls in the market – in the case where the rainfall was not as heavy as expected, and the demand has risen, ABC Inc would still be paying $10/ quintal, which may be exorbitant during the time. ABC Inc might have its margins affected too. Bruce Corns would be making clear profits from this forward contract.
Example #2 – Futures
Futures are similar to forwards. The major difference remains as Forward contracts are Over-the-Counter instruments. They can, therefore, be customized. The same contract if is traded through the exchange, it becomes a Future contract and is, therefore, an exchange-traded instrument where supervision of an exchange regulator exists.
- The above example can be a Future contract too. Corn Futures are trading in the market, and with news of heavy rainfall, corn futures with an expiry date of past six months can be purchased by ABC Inc at its current price, which is $40 per contract. ABC buys 10000 such future contracts. If it really rains, the futures contracts for corn become expensive and are trading at $60 per contract. ABC clearly makes a gain of $20000. However, if the rainfall prediction is wrong and the market is the same, with the improved production of corn, there is a huge demand among the customers. The prices gradually tend to decline. The future contract available now is worth $20. ABC Inc, in this case, would then decide to purchase more such contracts to square off any losses arising out of these contracts.
- The most practical example globally for future contracts is for commodity oil, which is scarce and has a huge demand. They are investing in oilInvesting In OilOil investing is trading or investing in oil sector through various means. Oil market exhibits huge price fluctuations on a daily basis due to which, only highly knowledgeable and experienced players stay for the long run. price contracts and, ultimately, gasoline.
Example #3 – Options
Out of the Money / In the money
When you are buying a call option – the strike price of the optionStrike Price Of The OptionExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market. will be based on the current stock price of the stock in the market. For example, if the share price of a given stock is at $1,500, the strike price above this would be termed as “out of the money,” and the vice-versa would be called “ in-the-moneyIn-the-moneyThe term "in the money" refers to an option that, if exercised, will result in a profit. It varies depending on whether the option is a call or a put. A call option is "in the money" when the strike price of the underlying asset is less than the market price. A put option is "in the money" when the strike price of the underlying asset is more than the market price..”
In the case of put options, the opposite holds true for out of the moneyOut Of The Money”Out of the money” is the term used in options trading & can be described as an option contract that has no intrinsic value if exercised today. In simple terms, such options trade below the value of an underlying asset and therefore, only have time value. and in the money options.
Purchasing Put or Call Option
When you are purchasing “ Put option,” you are actually foreseeing conditions where the market or the underlying stock to go down, i.e., you are bearishBearishBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market. over the stock. For example, if you are purchasing a put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated. for Microsoft Corp with its current market price of $126 per share, you are ultimately being bearish of the stock and expect it to fall may be up to $120 per share over a period of time, by looking at the current market scenario. So, since you make a purchase of MSFT.O stock at $126, and you see it declining, you can actually sell the option at the same price.
Example #4 – Swaps
Let us consider a vanilla swap where there are two parties involved – where one party pays a flexible interest rate, and the other pays a fixed interest rate.
The party with the flexible interest rate believes that the interest rates may go up and take advantage of that situation if it occurs by earning higher interest payments, while the party with the fixed interest rate assumes that the rates may increase and does not want to take any chances for which the rates are fixed.
So, for example, there are two parties, let’s say Sara & Co and Winrar & Co- involved who want to enter a one-year interest rate swap with a value of $10 million. Let’s assume the current rate of LIBOR is 3%. Sara & Co offers Winra &Co a fixed annual rate of 4% in exchange for LIBOR’s rate plus 1%. If the LIBOR Rate remains 3% at the end of the year, Sara & Co will pay $400,000, which is 4% of $10 mn.
In case LIBOR is 3.5% at the end of the year, Winrar & Co will have to make a payment of $450,000 (as agreed à 3.5%+1%=4.5% of $10 mn) to Sara & Co.
The value of the swap transaction, in this case, would be $50,000 – which is basically the difference between what is received and what is paid in terms of the interest payments. This is an Interest rate swapInterest Rate SwapAn interest rate swap is a deal between two parties on interest payments. The most common interest rate swap arrangement is when Party A agrees to make payments to Party B on a fixed interest rate, and Party B pays Party A on a floating interest rate. and is one of the most widely used derivatives globally.
Derivatives are instruments that help you to hedge or arbitrage. However, there can be few risks attached to them, and hence, the user should be careful while creating any strategy. It is based on one or more underlying; however, sometimes, it is impossible to know the real value of these underlying. Their complexity in accounting and handling make them difficult to price. Also, there is a very high potential of financial scams by the use of derivatives, for example, the Ponzi scheme of Bernie Madoff.
Therefore, the basic method of using Derivatives, which is leverage, should be wisely used as derivates still continue to remain an exciting yet hideous form of financial instrument for investment.
This has been a guide to Derivatives Examples. Here we discuss the most common examples of derivatives, including futures, forwards, options, and swaps, along with an explanation. You may learn more about derivatives from the following articles –