Derivatives instruments are a strategic asset class and a useful risk management tool required for surviving uncertainties in the financial markets.
What are Derivatives?
Derivatives are financial market products whose values are derived from one or more underlying assets or sets of assets, which can be bonds, stocks, commodities, precious metals, market indices, interest rates, etc.
Though the market price of a derivative product is based on and determined by the underlying asset, its ownership is distinct and exclusive. Derivatives can be traded OTC or on organised securities exchanges such as FMDQ OTC Securities Exchange.
The basic features of most derivatives products are discussed below: Future settlement date: A derivatives contract essentially specifies that the underlying asset (s) may be exchanged at a later date, and at a price fixed today.
Indeed, it is this time difference between the contract date and settlement date that creates the value traded in a derivatives contract, given that the market price of the underlying asset may be different by the settlement date.
Symmetrical vs. asymmetrical contracts: A derivatives contract can be symmetrical –in this case, the parties (buyer and seller) are both bound by an obligation to execute the contract by the settlement date.
A derivatives contract can also be asymmetrical, a situation whereby one party has the right, but not the obligation, to follow through with the contract.
Settlement procedures: A derivatives contract can be settled in cash (here, the difference in the price of the underlying asset on settlement date and the agreed contract price is computed and paid) or by physical delivery of the underlying asset. However, derivatives contracts are mostly settled in cash.
Zero-Sum game: Derivatives contracts are theoretically zero-sum games (excluding the associated transaction costs). By implication, the parties (buyer and seller) are competing, such that when one party wins, the other party loses.
Types of Derivatives Products
Broadly speaking, there are three (3) major types of derivatives: Futures/Forward contracts, Options and Swaps.
Futures/Forward contract:
In a futures/forward contract, two (2) counterparties agree to exchange a specified quantity of an underlying asset (real or financial) at an agreed-upon price (the strike price) on a specified date (settlement date).
Futures/forward contracts are usually written in reference to the spot or today’s price and typically used to hedge risk as well as speculate on future prices.
Examples of such contracts are foreign currency futures/forwards, interest rate futures/forwards, treasury-bills futures/forwards, etc.
Options Contract:
In an option contract, the buyer of an option contract pays a premium to the writer of the option. In return, the buyer acquires the right but not the obligation to buy (call option) or sell (put option) a specified underlying item (real or financial) at an agreed-upon contract price (the strike price) on or before a specified date. The major difference between forward and option contracts is that either party to a forward contract is a potential debtor, whereas the buyer of an option acquires an asset, and the option writer incurs a liability. Options are written on a wide variety of underlying items—such as equities, commodities, currencies, and interest rates. Options can be also written on futures, swaps (known as swaptions), and other instruments.
Swaps Contract:
A swap is a derivative contract made between two (2) parties to exchange cash flows in the future in line with a pre-arranged formula. The three (3) most popular swap contracts, which are traded OTC between derivatives market players, are interest rate swaps, currency swaps and commodity swaps. Interest rate swaps typically entail the swapping of interest related cash flows between parties in the same currency, whereas currency swaps are contracts between two (2) institutions to exchange the principal and/or interest payments on loans for equivalent amounts in a different currency. Similarly, a commodity swap is an OTC contract to exchange cash flows, which are dependent on the price of an underlying commodity.
In exploring the fundamentals of the derivatives market, the following terminologies, among others, are key to note: Market Maker: A market maker is a player who provides both buy and sell quotes to other market participants/traders. The market maker essentially provides liquidity to the derivatives market. Bid-Ask Spread: This is the difference between the bid price (the price the buyer is willing to pay) and the ask price (the price a seller is willing to accept) in a derivatives contract. Market makers always give two (2) sets of prices (buy and sell) in the derivatives market.
Strike price: The price at which the holder of a derivatives contract exercises his/her/its right if it is economic to do so, at the appropriate point in time.
Call/Put Option: A Call Option conveys to the option buyer the right (but not the obligation) to purchase the underlying asset at a fixed strike price per unit at any time during the life of the option. A Put Option, on the other hand, conveys to the option buyer the right (but not the obligation) to sell a predefined quantity of the underlying asset at the pre-determined strike price.
Margin:
This refers to funds that a derivatives investor/trader must maintain on deposit with his/her/its broker to guarantee his /her/its ability to fulfil his /her/its financial obligation to make or take delivery of the underlying asset.
Clearing House: A clearing house is an intermediary between buyers and sellers in the derivatives market, responsible for settling trading accounts, clearing trades, collecting and maintaining margin monies, regulating delivery, and reporting trading data. It guarantees the performance and settlement of exchange traded contracts to its members. Essentially, clearing houses act as third parties to all Futures and Options contracts.
Exercise Price: This is the fixed price per unit at which a call option conveys the right to purchase the underlying asset and at which a put option conveys the right to sell the underlying asset.
Long/Short Position: Purchasing a derivatives contract puts a trader (buyer) on the long side of the contract, simply referred to as ‘going long’. A short position is the opposite of going long, and refers to the selling side of a derivatives contract.
Spot Contract: A spot contract is a contract for immediate delivery. Since derivatives, by definition, include delivery at a future date, spot contracts usually do not form part of the derivatives market. However, they do provide the reference price/rate for the pricing of Futures, Forwards and Options.
Expiration Date: Derivatives are time bound financial instruments. An expiration date is when the contract is finally settled, signifying the end of the agreement. Expiration dates are commonly used with Options contracts.
Settlement Date: Settlement date is the day on which a trade or a derivatives contract (particularly Forwards, Swaps or Futures transactions) must be settled either in cash, or via the transfer of the underlying asset.
