What are Derivatives in Finance?
Derivatives 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.
Most Common Derivatives in Finance
The following are the top 4 types of derivativesTypes Of DerivativesA derivative is a financial instrument whose structure of payoff is derived from the value of the underlying assets. The three types of derivatives are forward contract, futures contract, and options. in finance.
# 1- Future
A futures derivative contract in finance is an agreement between two parties to buy/sell the commodity or financial instrument at a predetermined price on a specified date.
#2 – Forward
A forward contract works in the same way as the futures, the only difference being, it is traded over the counter. So there is a benefit of customization.
#3 – Option
Options in financeOptions In FinanceOptions 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. also work on the same principle. The however biggest advantage of options is that they give the buyer a right and not an obligation to buy or sell an asset, unlike other agreements where exchanging is an obligation.
#4 – Swap
A swap is a derivative contractSwap Is A Derivative ContractSwaps 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. in finance where the buyer and seller settle the cash flows on predetermined dates.
There are investors/investment managers in the market who are called the market makersMarket MakersMarket makers are the financial institution and investment banks which ensures enough amount of liquidity in the market by maintaining enough trading volume in the market so that trading can be done without any problem.. They maintain the bid and offer prices in a given security and stand ready to buy or sell lots of those securities at quoted prices.
Use of Derivatives in Finance
#1 – Forward Contract
Suppose a company from the United States is going to receive payment of €15M in 3 months. The company is worried that the euro will depreciate and is thinking of using a forward contractForward ContractA forward contract is a customized agreement between two parties to buy or sell an underlying asset in the future at a price agreed upon today (known as the forward price). to hedge the risk. This effectively means they fear they will receive less $ when they go out to exchange their € in the market. Therefore by using a forward contract, the company can sell the euro right now at a predetermined overhead ratePredetermined Overhead RatePredetermined overhead rate is the distribution of expected manufacturing cost to the presumed units of machine-hours, direct labour hours, direct material, etc., for acquiring the per-unit expense before every accounting period. and avoid the risk of receiving less $.
#2 – Future Contract
To keep it simple and clear, the same example as above can be taken to explain the futures contract. However, the futures contract has some major Differences as compared to forwards. Futures are Exchange-traded. Therefore they are governed and regulated by the exchange. Unlike forwards, which can be customized and structured as per the parties’ needs. Which is why there is much less credit, counterparty riskCounterparty RiskCounterparty risk refers to the risk of potential expected losses for one counterparty as a result of another counterparty defaulting on or before the maturity of the derivative contract. in forwards as they are designed according to the parties’ needs.
#3 – Options
An investor has $10,000 to invest; he believes that the price of stock X will increase in a month’s time. The current price is $30; in order to speculate, the investor can buy a 1-month call option with a strike priceStrike PriceExercise 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. of let’s say $35. He could simply pay the premium and go long call on this particular stock instead of buying the shares. The mechanism of our option is exactly the opposite of a call.
#4 – Swaps
Let’s say a company wants to borrow € 1,000,000 at a fixed rate in the market but ends up buying at the floating rate due to some research-based factors and comparative advantageComparative AdvantageIn order to determine comparative advantage, the opportunity cost of each item from each country needs to be calculated. Then, on a comparative table, these costs are plotted to get the comparative advantage.. Another company in the market wants to buy € 1,000,000 at the floating rate but ends up buying at a fixed rate due to some internal constraints or simply because of low ratings. This is where the market for swap is created. Both the companies can enter into a swap agreement promising to pay each other their agreed obligation.
Calculation Mechanism of Derivatives Instruments in Finance
- The payoff for a forward derivative contract in finance is calculated as the difference between the spot priceSpot PriceA spot price is the current market price of a commodity, financial product, or derivative product, and it is the price at which an investor or trader can buy or sell an asset or security for immediate delivery. and the delivery price, St-K. Where St is the price at the time contract was initiated, and k is the price the parties have agreed to expire the contract at.
- The payoff for a futures contract is calculated as the difference between the closing price of yesterday and the closing price of today. Based on the difference, it is determined who has gained, the buyer or the seller. Suppose the prices have decreased, the seller gains, whereas if the prices increased, the buyer gains. This is known as the mark to market payment model where the gains and losses are calculated on a daily basis, and the parties are notified of their obligation accordingly.
- The payoff schedule for options is a little more complicated.
- Call Options: Gives the buyer a right but not an obligation to buy the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates. as per the agreement in exchange for a premium, it is calculated as- max (0, St – X). Where St is the stock price at maturity and X is the strike price agreed between by the parties and the 0 whichever is greater. To calculate the profit from this position, the buyer will have to remove the premium from the payoff.
- Put Options: Gives the buyer a right but not an obligation to sell the underlying asset as per the agreement in exchange for a premium. The calculation schedule for these options is exactly the reverse of calls, i.e., strike minus the spot.
- The payoff for swap contracts is calculated by netting the cash flow for both the counterparties. An example of a simple vanilla swap will help solidify the concept.
Advantages of Derivatives
- It allows the parties to take ownership of the underlying asset through minimum investment.
- It allows them to play around in the market and transfer the risk to other parties.
- It allows for speculating in the market. As such, anyone having an opinion or intuition with some amount to invest can take positions in the market with the possibility of reaping high rewards.
- In case of options, one can buy OTC over the counterOver The CounterOver the counter (OTC) is the process of stock trading for the companies that don't hold a place on formal exchange listings. The broker-dealer network facilitates such decentralized trading of derivatives, equity and debt instruments. customized option that suits their need and make an investment as per their intuition. The same applies to forward contracts.
- Similarly, in the case of futures contracts, counterparty trades with the exchange, so it’s highly regulated and organized.
Disadvantages of Derivatives
- The underlying assets in the contracts are exposed to high risk due to various factors like volatility in the market, economic instability, political inefficiency, etc. Therefore as much as they provide ownership, they are severely exposed to risk.
- Dealing in derivatives contracts in financeDerivatives Contracts In FinanceDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based. requires a high level of expertise because of the complex nature of the instruments. Therefore a layman is better off investing in easier avenues like mutual funds/ stocks or fixed incomeFixed IncomeFixed Income refers to those investments that pay fixed interests and dividends to the investors until maturity. Government and corporate bonds are examples of fixed income investments..
- Famous investor and philanthropist Warren Buffet once called derivatives’ weapons of mass destruction’ because of its inextricable link to other assets/product classes.
The bottom line is although it gives exposure to high-value investment, in the real sense, it is very risky and requires a great level of expertise and juggling techniques to avoid and shift the risk. The number of risks it exposes you to is multiple. Therefore unless one can measure and sustain the risk involved, investing in a big position is not advisable. Conversely, a well-calibrated approach with calculated risk structure can take an investor a long way in the world of financial derivatives.
This has been a guide to what are Derivatives in Finance & its definition. Here we discuss the most common derivatives in finance along with its advantages and disadvantages. You can learn more about accounting from the following articles –