Derivatives Features

Nature of Derivatives

Derivatives are financial products or assets whose value is indirectly derived from an underlying product or asset.  The main types of financial derivatives are swaps, options, and futures.  Swaps involve one party exchanging an obligation for another.  Interest rates and r currencies are commonly the subject of swaps.

Options entitle a buyer to sell or buy an amount of underlying assets such as a commodity, shares or bonds.  Future or forward obliges a buyer to buy or sell a particular asset at a particular price in the future.

Some derivatives may be traded on formal exchanges with rules in relation to participation and account clearing.  Other derivatives are agreed on a contractual business basis without an exchange and are referred to as over-the-counter derivatives.  Derivatives can be used to protect against risk.  They can also be used for speculation.

Derivatives may be transferred.  A contract may be transferred between two parties provided there is no express or implied restriction on the contract and the other party to the contract is notified of the new contract holder.  Financial derivatives are tradable.

Hedging

Hedging offsets risk by providing a balancing obligation or right.  Derivatives may move in value in a particular direction depending on movements in another asset.  Risk management through hedging seeks to find an asset that moves in the opposite direction to another risky asset thereby offsetting or hedging the risk.

A particular type of asset may make higher returns when interest rates are low but fall when interest rates rise. Another type of asset may rise in value as interest rates rise. Rather than buying these underlying assets, derivatives may be designed through financial engineering, which moves with reference to the value of the other assets with the opposite characteristic.

The use of derivatives and hedging techniques can be extremely sophisticated.  Complex derivative assets can be created to offset or reduce risks in a particular type of portfolio.  A further and common example may be seen in the contrast between fixed and floating interest rates.

A lender who has borrowed at a floating interest rate may (usually through the lender) swap his interest rates for a fixed interest period, thereby changing the interest rate and the risk associated with future rises in interest rates.  There will need to be some counterparty at some other end with an equal but opposite requirement.

Speculation

Derivatives also allow for speculation in that they allow leverage or amplification of risks and losses. Derivatives may allow investors to speculate on movements in financial markets without owning shares traded in the market itself.

A speculator may purchase an option to buy shares at a particular price without actually buying the shares.  If the shares do not increase to the option price, the option will not be exercised.  If the share prices increase, the speculator may sell the option for the difference between the option price and the market price.

The speculator has made a profit without dealing with the market and engaging transaction and registration costs.  In addition, there is less direct regulation and greater anonymity.  The transaction may happen in a different jurisdiction than that in which the underlying shares or assets are traded or registered.

Arbitrage / Leverage

Persons trading in security markets may use derivatives such as options to make profits on fluctuations in the market.  So-called arbitrage involves the making of profit during the adjustment of the market to the clearing price.  Such profits would only be available for a very short term.

Derivatives allow for the magnification of risk and returns.  With a derivative, a relatively small amount of cash only, may be required to be put down.

In organised markets, it may only be necessary to meet a margin between the likely loss or cost of an asset at a given point.  A relatively small upfront sum may finance a relatively large gain.  Equally, the risk of loss is amplified by downward movements.

Cash-settled derivatives mean that the investor does not acquire the actual product but instead pays/ receives the amount equivalent to the loss/profit he she would have made if she had invested in the product. Cash-settled financial derivatives are often referred to as contracts for differences.

Options

An option is a right to buy or sell an asset without an obligation to do so. The option is a derivative as it derives its value from the underlying share. A put option is the option or right to require another person to purchase an asset at a given amount or a given price or a price to be determined.  A call option is a right to purchase an asset at a particular time or quantity or during a particular period.

Because there is no obligation to exercise an option, the option will (almost invariably) only be exercised if it is profitable.  A call option may be exercised so that the person acquires the underlying asset.

Alternatively, and more commonly in financial markets, the assets or option is settled in cash without any assets being transferred.  The investor obtains the profit that he would have obtained had he bought the underlying asset. Derivatives may facilitate dealing across jurisdictions as they remove the need to buy the underlying asset.

Options may be exercised at a single point in time.  This is commonly described as a European option.  An American option is one which may be settled between or before specified date(s).  The risk profile of each type of option varies as the American option gives the holder greater flexibility.

Use of Options

An investor may wish to speculate that the price of a share will increase, say, from €1 to €1.20.  He may buy a call option on the shares, entitling him to purchase those shares on a future date for, say, a current price below that which the investor expects will then prevail.

If the future price increase materialises, the investor may purchase these shares at the lower option price and seldom at the higher market price.  More commonly, however, the option would simply be cash settled so that the investor would be entitled to the difference between the market price and the option price.

Investment banks are generally the counterparties to derivative contracts.  In the above case the investor would pay a premium for the benefit of the option.  If the option is worth exercising, it will be settled by payment of the net surplus.  If the buyer does not exercise the option, then the premium is lost.

The option agreement will specify the manner in which the option is to be exercised.  Some options contracts will provide that they are to be exercised automatically if they have a value or are “in the money.” Different techniques may be specified in the contract for the exercise of the option.

Future and Forwards

A forward contract is a promise to supply a particular asset at a particular price on a particular date.  The buyer must pay the price irrespective of whether the price is profitable or not.  Unlike an option, it must be exercised.

Originally forwards and futures related to commodities such as wheat.  They evolved over time to relate also to underlying financial assets. A forward gives the right to purchase or sell a future amount of an asset at a fixed price at a fixed date in the future.

Futures contracts are standardized contracts which are traded on an exchange.  The contracts are standardized the amounts fixed, and differences and variations in price must be settled with the exchange on an ongoing basis. In contrast to futures forwards as in standardized form.

Swaps

Swaps involve the exchange of one type of an obligation for another.  A common example is an interest rate swap, by which the obligation to pay a fixed rate interest for a period is swapped with the obligation to pay a floating rate interest for the same period.

A bank will sell the swap and will generally offset the equal and opposite obligation with another party, actually or notionally in aggregate. Interest rate swaps may operate by reference to notional loan amounts rather than actual loans.  This facilitates the use of the swap for speculation.

Under the swap agreement one party agrees to pay the other on a specified date or dates, the amount calculated by reference to the interest which would have accrued on a notional principal. There are different interest rates payable in each case.

One interest rate may be fixed while the other may vary by reference to a reference rate such as the Euribor.  Instead of each paying the respective amounts, each party pays each other the settlement amount due as the case may be on a net basis.

One customer may wish to fix its interest rate, but its lender may not be willing to contract on this basis. It may be able to source a swap by which it may exchange its floating rate obligations for fixed rate obligations by way of an interest rate swap.

One financial institution will owe the respective of obligations under each type of interest rate but will set off or net out the differences.  On each payment date,  either party may be obliged to pay the other depending on which payment exceeds the other on the relevant date. The lender will also charge a fee for the hedging arrangement as well as seeking a profit on the different expectations regarding interest rates.

Swap Variants

A swap is in essence an exchange of cash flows.  A swap involving a return on a based interest rate such as the Euribor as against the return on equity portfolio is an equity swap. A speculator may bet that one exchange of cash flow will work in his favour. For example, a speculator may enter a swap with a financial institution to receive a return which it would have received on paying floating rate interest as against the return on a particular  market.

The return will be calculated by reference to a notional amount of capital and a notional investment of money in the market.  This would be equivalent to borrowing at the interest rate and investing in these shares without actually acquiring the underlying asset.  The net amount will be paid to the person with the profitable position.

More complex products may involve baskets of currencies and stocks as the variable payment, in exchange for fixed rate interest payments linked to an underlying cost of funds. These techniques replicate the effect of investment in portfolios across ranges of market. One of the parties, usually the seller will act as a calculation agent.

Currency swaps are commonly used so, by which parties exchange amounts in one currency for another or speculate against different exchange or interest rates in currencies. In a currency swap, the parties agree to pay each other,  the interest rate that would have been paid on the money markets in the two different currencies.  Some currency swaps involve the actual delivery of currency.

Swaps in essence constitute obligations to make a series of future payments.  By providing that each payment is separate, the risk of insolvency at a future date is reduced as each transaction is completed as it is paid. This means that in the event of insolvency each future payment is considered rather than the insolvency applying to the entire contract, which would increase the insolvency risk.

Credit derivatives seek to provide protection against defaults in future payments.  The credit derivative provides a return calculated by reference to the credit performance of another entity.  The credit derivatives may, for example, pay a shortfall on a future payment in the event of a default.

A speculator may purchase to position whether or not he/ it owns the underlying assets.  It is effectively speculating on whether the entity may default on payment.  The degree of default required for payment will depend on the terms of the agreement.  It may be triggered by a downgrade or change in the net present value of the reference entity due to a restructuring.