Derivatives – COGNOSCENTE FINTECH

What are derivatives?

The term derivative refers to a type of financial contract whose value is dependent on an underlying asset, group of assets or benchmark. A derivative is set between two or more parties that can trade on an exchange or Over the Counter(OTC).These contracts can be used to trade any number of assets and carry their own risks. Prices for derivatives derive from fluctuations in the underlying asset. These financial securities are commonly used to access certain markets and may be traded to hedge against risk.

Understanding Derivatives

A derivative is a complex type of financial security that is set between two or more parties. Traders use derivatives to access specific markets and trade different assets. The most common underlying assets for derivatives are stocks, bonds, commodities, currencies, interest rates, and market indexes. Contract values depend on changes in the prices of the underlying asset.

Derivatives can be used to hedge a position, speculate on the directional movement of an underlying asset, or give leverage to holdings. These assets are commonly traded on exchanges or over-the-counter (OTC) and are purchased through brokerages.

OTC-traded derivatives generally have a greater possibility of counterparty risk, which is the danger that one of the parties involved in the transaction might default. These contracts trade between two private parties and are unregulated. To hedge this risk, the investor could purchase a currency derivative to lock in a specific exchange rate. Derivatives that could be used to hedge this kind of risk include currency futures and currency swaps.

Types Of Derivatives

Derivatives are now based on a wide variety of transactions and have many more uses. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a region.

There are many different types of derivatives that can be used for risk management, speculation, and leveraging a position. The derivatives market is one that continues to grow, offering products to fit nearly any need or risk tolerance. The most common types of derivatives are futures, forwards, swaps, and options.

How do derivatives affect the market?

The capacity and opportunities to make colossal and huge profits is high in derivatives than in case of essential securities or mutual funds. In any case, since the estimation of derivatives depends on certain fundamental things, for example, wares, metals and stocks and so forth, they are presented to high chance. A large portion of the derivatives are exchanged on open market. Furthermore, the costs of these products metals and stocks will be consistently changing in nature. So the danger that one may lose their worth is high.

What are the advantages of derivatives?

Advantages of derivatives are:

Derivatives can be utilized to shield risk just as gain risk. Theorists can purchase a resource at a low cost later on.
Derivatives help to decrease market exchange costs as they go about as a tool for managing the risk factor.
Derivatives increase the market efficiency as the price of the underlying asset and the related derivative are balanced.
Derivatives increase the access to markets that may generally be unavailable to traders.

What are future Contracts and how do they work ?

Derivative Trading has proved to be highly profitable for investors looking to diversify their portfolios by investing in other asset classes. Among derivatives, some choose options trading while some prefer Futures trading. However, given the complexity of futures contracts, you need to understand everything regarding the financial instrument.

A Futures contract is a legal agreement involving the sale and purchase of a certain commodity, asset, or security at a predetermined price and date in the future. To facilitate their trade on the futures exchange, futures contracts are standardised to check for quantity and quality.

The individual who purchases the future contract is obliged to purchase and/or receive the underlying asset before the futures contract expires. The seller of this contract takes on the obligation to provide and deliver the asset on which the futures contract is based to the buyer at the time the futures contract is exercised.

Future contracts allow an investor to speculate the direction in which the underlying assets such as a commodity, security, or financial instrument will move. These contracts are often purchased with the goal of hedging price movements of the underlying asset to prevent losses from rather unfavourable price changes.

Example of Future Contract

Suppose an oil producer wants to sell oil but fears that the oil prices may fall in the future. To ensure the oil producer gets a predetermined price and not incur a loss, a futures contract can be used. With the aid of future contracts, the oil producer can lock in the price at which the oil will sell thereby delivering the oil to the buyer, once the future contract expires. On the other hand, a manufacturing company may require oil to use for making widgets. Since this company prepares well by planning ahead and prefers to have oil coming in each month, they may also employ the use of a future contract. This way the company knows the price at which they will receive oil, based on the price set in their future contract. They know that they will be taking up the delivery of that oil once their contract expires.

Difference between Futures and forward contract

The term futures is a rather general way often used to refer to the entire market. Unlike forward contracts, as mentioned earlier, futures contracts are standarised. Forwards or forward contracts are similar types of agreements that lock in a future price in the present. However, forwards are traded over-the-counter (OTC) and have terms that are customisable. Alternatively, a future contract will have the same terms of selling and purchase, irrespective of the counterparty.

Difference between a hedge and a derivative

Hedging is a speculation methodology and procedure to prevent loss and dangers in any market circumstance. It goes about as a preventive measure – like protection. Derivatives are only one of the hedging instruments. In various circumstances, hedging can either bring about a profit or a loss. Derivatives are instruments that add to one or the other outcome. Hedging is a term, which signifies to move risk. Derivatives are instruments or securities that a speculator utilizes for various reasons including hedging. These securities are called derivatives since they are gotten from some basic resource.

What are swaps?

A derivatives contract is one of the best diversification and trading instruments used by both investors and traders. Based on its structure, it can be broadly divided into the following two categories; Contingent claims, otherwise known as options and forward claims, such as exchange-traded futures, swaps, or forward contracts. From these categories, swap derivatives are effectively used to exchange liabilities. These are an agreement between two parties to exchange a sequence of cash flows over a certain duration.

What is Swap trading?

A swap Derivative is a contract wherein two parties decide to exchange liabilities or cash flows from separate financial instruments. Often, swap trading is based on loans or bonds, otherwise known as a notional principal amount. However, the underlying instrument used in Swaps can be anything as long as it has a legal, financial value. Mostly, in a swap contract, the principal amount does not change hands and stays with the original owner. While one cash flow may be fixed, the other remains variable and is based on a floating currency exchange rate, benchmark interest rate, or index rate.

Typically, at the time someone initiates the contract, at least one of these cash flows is determined through an uncertain or random variable, like foreign exchange rate, interest rate, equity price, or a commodity price.

Types of Swaps

Interest Rate Swaps: The idea behind an interest rate swap is to switch the cash flows from a fixed interest rate to a floating interest rate. In such a swap, Party A agrees to pay a fixed rate of interest to Party B on a notional principal for a specified period and on predetermined intervals.

For instance, Argentina and China have used this swap, allowing China to stabilise its foreign reserves. Another example is the use of currency swaps by the federal reserve of the USA engaging in aggressive currency swap agreements with European central banks. This was done during the 2010 financial crisis in Europe to stabilise the euro that had been falling as a result of the Greek debt crisis.

Total Returns Swap: In total returns swaps, the total return from a particular asset is swapped for a fixed interest rate. The party that pays the fixed rate takes on the exposure towards the underlying asset, be it a stock or an index. For instance, an investor can pay a fixed rate to a party in return for exposure to stocks, realising the capital appreciation and earning the dividend payments, if any.

Commodity Swaps: Commodity swaps are used to exchange cash flows that are dependent on a commodity price. As the price of commodities is floating, one party exchanges this floating rate for a fixed rate. For example, a producer can swap the spot price of Brent Crude oil for a price that is set over an agreed-upon period. It allows producers to lock in a set price and mitigate losses based on future price fluctuations.

Currency Swaps: In a currency swap, both parties exchange principal and interest payments on debt that is denominated in different currencies agreed by the parties. Unlike an interest rate swap, the principal is often not a notional but is exchanged along with interest obligations. Currency swaps can take place between different countries. Consequently, Party B agrees to make payments to Party A on a floating interest rate with the same notional principal, the same amount of time, and the same intervals. The same currency is used to pay the two cash flows in a classic interest swap, otherwise known as a plain vanilla interest swap. The predetermined payment dates are known as settlement dates, and the time between them is called the settlement period. As swaps are customised contracts, payments can be made monthly, quarterly, annually, or at any interval determined by the parties.

Debt-Equity Swaps: A debt-equity swap involves the swapping of equity for debt and vice versa. It is a financial restructuring process where one party exchanges/cancels another party’s debt in exchange for an equity position. For a publicly-traded company, this would mean exchanging bonds for stocks. Debt-equity swaps are a means for a company to refinance its debt as well as relocate its capital structure.

What are forward contracts and how do they work?

The Indian financial market and its numerous investment instruments come with their risks and rewards. While investors can reap the rewards with the right amount of research and an ideal trading strategy, the risks can seem harder to manage and minimise if the investors are not well versed with the financial market. In the world of derivatives trading, these risks are often mitigated by traders with the aid of a forward contract.

What is a forward contract

A forwards contract is a specific agreement by two parties to purchase or sell an asset at a particular price on a future date. The two parties agree to conduct the said transaction in the future, hence the term ‘forward’. The value of the forward contract is derived from the underlying asset’s value, such as stocks, commodities, currencies etc. This is why a forward contract acts as a derivative. However, unlike an options contract, the two parties involved in a forwards derivative contract are obligated to fulfil the specified transaction and take the delivery of the underlying asset.

Forward contracts are not traded on a centralised exchange, which is why they are essentially considered over-the-counter or OTC derivatives. Furthermore, since forward contracts are negotiated privately and without an intermediary, they are more customisable than standard derivative contracts.

How Is Forward Trading Done?

The two parties typically enter into a forward contract because of their opposing views on a particular asset’s future price. One party believes that the price of a particular asset is set to rise in the future and therefore wishes to purchase it at a lower, predetermined price to make profits based on the price difference. Hence, this party offers to be the buyer. On the other hand, the other party believes that the asset’s price will fall in the near future and therefore wishes to cut their losses by locking in a predetermined price. This party, therefore, offers to be the seller.

The Price Of The Asset Rises In The Future: In this scenario, the buyer’s prediction comes true, and they can sell the asset at a higher price. They take the delivery of the asset by paying the lower predetermined price of the forwards’ contract and sell it on the open market. The profit made by the buyer in this scenario is the difference between the actual current price of the asset and the locked-in price at which the buyer bought it.

The Price Of The Asset Falls In The Future: In this scenario, the seller’s prediction is correct, providing benefits from the sale made through the forward contract. Even though the price of the asset has fallen, the seller gets to sell it at a price higher than its current value. The profit made by the seller in this scenario is the difference between the price at which the seller sells the asset and the actual current price of the asset.

The Price Of The Asset Remains Unchanged In The Future: In this scenario, the prediction of neither the buyer nor the seller is proven correct. Therefore, the transaction results in no profit made or loss incurred by either party.

Example Of a Forwards Contract

To understand the concept better, let us take a forward contract example. Let’s say a farmer is on track to harvest 20 tonnes of maize by next year. To make a profit on his harvest, he must sell it at a price of at least Rs 10,000 per tonne. If the farmer chooses to wait till next year to sell his maize harvest, he may or may not be able to make a profit on the transaction. This is because there is no saying what the price per tonne will be next year.However, if the farmer chooses to enter into a forward contract with a food manufacturing company that guarantees to pay him his desired price in exchange for his harvest next year, his risk is minimised. Therefore, even if the price of maize falls next year, he will be protected by the obligation of the forward contract and the fact that he will receive a higher price based on the lock-n price.

What Are Options?

An Options contract is essentially a type of agreement between two parties, whereby the buyer has the right but not the obligation to buy or sell an underlying asset. The asset must be bought or sold – depending on the type of options contract- on the specific date and at a predetermined asset price. Some of the essential terms that are often used in options trading are:

Lot Size: This refers to the standard quantity or units of the underlying asset that is included in the options contract.

What Are Put Options And How It Works?

A put option is a derivative contract that allows a person to attain the right, but not the obligation, to sell a specified amount of the underlying asset at a certain price and date. This specified price as decided upon through the contract is referred to as the strike price.

A put option is an ideal tool for sellers who want to safeguard their investment in case the price of the underlying asset falls in the future. The underlying asset’s value may fall beneath what the buyer had promised to pay for it. Thus, causing a loss to the buyer. However, as the contracting parties have already agreed on a strike price, the seller receives the predetermined strike price even when the current price is lower. This allows the seller to make huge profits even when the asset’s market value has fallen.

What Are the Advantages Of Put Options?

Since buying an options contract involves deciding between buying a put or a call option, it is important to understand the advantages. However, when compared with each other, a put option offers better advantages than a call option. Read on to learn the advantages offered by a put option that is unavailable with a call option.

Favourable Time Decay: Time is of the essence when you enter into derivative trading intending to make profits, and options are a time-bound asset that provides the put sellers with a favourable advantage. The nearer an options contract is to the completion of its specified period, the less valuable it becomes. Thus, the put option sellers are likely to benefit through the time decay by selling the contract while the option still offers value to them. In this case, however, the person with the call option is not favoured by the time decay.

Favourable Price Direction: The stock or the underlying asset of an option can move in any direction. It can rise or fall significantly based on social, economic and political developments. As an investor with a call option, it becomes necessary to buy the option at a price lower than the strike price for it to be profitable. However, investors with a put option can profit if the underlying asset’s price remains unchanged or even if it drops slightly. This ensures that a trader with a put option is more likely to profit than a call option’s trader.

Favourable Implied Volatility: Implied volatility refers to an option contract’s expensiveness. When the implied volatility in a market is high, the option contract’s price tends to be more expensive. As a trader with a put option, you would want to sell when the price is high and buy the assets when the price drops. This is possible only when the implied volatility is high but decreases subsequently with time. Market observers over the years have noted that high implied volatility has a natural tendency to drop over time, which means that traders with a put option are bound to make profits over some time since the natural conditions of the market are in their favour.

What Are Over The Counter (OTC) Derivatives?

An over-the-counter (OTC) derivative is a financial contract that does not trade on an asset exchange, and which can be tailored to each party’s needs. A derivative is a security with a price that is dependent upon or derived from one or more underlying assets.

Derivative are types of securities where the prices are determined by the value of its intrinsic or underlying asset. These assets could be stocks, bonds, commodities etc. Some common types of derivatives trading include derivative securities such as forwards, futures, options and swaps.

Derivatives trading can protect against the risks associated with the price movements of the underlying assets. The traders dealing with derivatives securities are called hedgers or speculators. Along with hedging against price movements, derivatives trading can also allow trading firms to negotiate better terms of trade. At times, fund managers use derivatives trading to manage their investment portfolios’ targeted asset allocation.

Derivatives are traded in two types of markets: in a central trading exchange such as the National Stock Exchange (NSE), Bombay Stock Exchange and Multi Commodity Exchange of India Ltd (MCX) or via an over-the-counter market. The derivatives traded through centralised stock exchanges are known as Exchange Traded Derivatives (ETDs). In contrast, those traded between two or more different parties without the involvement of stock exchanges or any other formal intermediary are known as over-the-counter derivatives.

Types of OTC Derivatives

Over-the-counter trading can be of the following types based on the below-listed underlying assets:

Interest Rate Derivatives: Here, the underlying asset is a standard interest rate. Swaps, which involve an exchange of cash flows over a period of time, are an example of interest rate OTC derivative trading.
Commodity Derivatives: Commodity derivatives have underlying assets that are physical commodities such as gold, food grains etc. Forward contracts are an example of OTC trading in commodity derivatives.
Equity Derivatives: In equity derivatives, the underlying assets are equities. Options and Futures are an example of OTC trading in equity derivatives.
Forex Derivatives: In forex derivatives, the underlying assets are changes in foreign exchange rates.
Credit Derivatives: Here, one party transfers the credit risk to another without any underlying asset exchange. Credit derivatives can either be funded or unfunded. Credit Default Swap (CDS) and Credit Linked Notes (CLNs) are examples of OTC trading in credit derivatives.

Disadvantages Of OTC Derivatives

Over-the-counter trading has some disadvantages as well. Here’s a look:

Any OTC contract runs the associated risk of credit or default as there is no central mechanism to clear and settle the transactions.
Any OTC contract is fraught with inherent and systemic risks in the absence of standarised regulations and norms.
OTC contracts are inherently speculative, thus having the possibility of creating market integrity issues and forcing traders to make losses.

What Are Call Options And How It Works?

A call option is a contract between two parties wherein one party has the right, but not the obligation, to buy a certain underlying asset at a pre decided price and on a future date.

Since there is no obligation on the need to make the purchase as dictated by the call options contract, you are not legally obliged to execute the options contract unless it is profitable to you.

The purchase of call option can only be profitable if the previously decided upon amount is lesser than the underlying asset’s current price on the date the options contract is exercised. This predetermined price of the underlying asset is called the strike price. Unless your strike price is lesser than the underlying asset’s price on the date of execution, you will end up bearing losses through the call option.

What Are the Advantages Of Call Options?

As mentioned earlier, most investors prefer buying call options rather than put options. There are several reasons for their preference, which are listed below:

Cost-Effective Investment: Investing in equities or similar investments can often require you to set aside a high amount of capital to make the investment viable and earn good returns. However, by buying a call option, you are simply paying for the premium which is dependent on the underlying asset, making it more affordable to buy. In this manner, you can invest through cost-effective means through a call option.

Lesser Risks: Investing in a call option is significantly less risky than investing directly into equity or other instruments. As call options are not highly volatile in nature, they can offer ideal risk management. The full extent of your losses on a failed call option is the nominal amount you pay as a premium for the right to purchase the call option.

Earn Premium Through Covered Calls: Even after buying a call option, you can generate additional revenue by selling the call option contract in the secondary market. If the underlying asset that you bought a while ago has appreciated in value, you can write a call option wherein the strike price is the current market value, and earn a premium on it. This transaction is referred to as covered call in options terms and enables investors to earn additional profits.

How Over-the-Counter Derivatives Work

Over-the-counter derivatives are private financial contracts established between two or more counterparties. In contrast, listed derivatives trade on exchanges and are more structured and standardized contracts in which the underlying assets, the quantity of the underlying assets and settlement are specified by the exchange and subject to greater regulation.

Over the Counter derivatives are instead private contracts that are negotiated between counterparties without going through an exchange or other type of formal intermediaries, although a broker may help arrange the trade. Therefore, over-the-counter derivatives could be negotiated and customized to suit the exact risk and return needed by each party. Although this type of derivative offers flexibility, it poses credit risk because there is no clearing corporation. Examples of OTC derivatives include forwards, swaps, and exotic options, among others.

Advantages Of OTC Derivatives

The benefits of over-the-counter trading include:

It allows small companies to engage in trade without being listed on stock exchanges. These companies can also stand to benefit from lesser financial and administrative costs compared to companies listed on stock exchanges.
It can be used for hedging, transferring trading risks, and as leverage for business operations.
It can allow for increased flexibility as the companies don’t have to abide by the standardised norms vis-a-vis exchange-traded derivatives.
It can allow companies to provide stable prices to their customers.