Derivatives Explained: Futures, Options, Swaps & Forwards

DERIVATIVES  What are they ? A type of financial contract whose value is dependent on an underlying asset, a group of assets, or a benchmark. Derivatives are agreements set between two or more parties that can be traded on an exchange or over the c...

DERIVATIVES  What are they ? A type of financial contract whose value is dependent on an underlying asset, a group of assets, or a benchmark. Derivatives are agreements set between two or more parties that can be traded on an exchange or over the counter (OTC). Can be used to trade any number of assets and come with their own risks. Prices for derivatives derive from fluctuations in the prices of underlying assets. Derivatives can be used to either mitigate risk (hedging) or assume risk with the expectation of commensurate reward (speculation). Derivatives can move risk levels (and the accompanying rewards) from the risk-averse to the risk seekers.  Over the counter Over-the-counter (OTC) market securities are traded without being listed on an exchange. Securities trade OTC through a dealer or broker specializing in OTC markets. OTC trading helps small investors enter the market.  Hedging Derivatives can be used to hedge, speculate on the directional movement of an underlying asset, or leverage a position. The Chicago Mercantile Exchange (CME) is among the world’s largest derivatives exchanges. It’s important to remember that when companies hedge, they’re not speculating on the price of the commodity. Instead, the hedge is an attempt to limit existing risks. Each party has its profit or margin built into the price, and the hedge helps protect those profits from being eliminated by unfavorable market moves in the price of the underlying asset.  Counterparty risk OTC-traded derivatives generally carry a greater counterparty risk - the danger that one of the parties involved in the transaction might not deliver on its obligations, or default. OTC contracts are privately negotiated between two counterparties and are unregulated. To hedge this risk, the investor could purchase a currency derivative to, for example, lock in a specific exchange rate. Derivatives that could be used to hedge forex risk include currency futures and currency swaps. Considerations Derivatives were originally used to ensure balanced exchange rates for internationally traded goods. International traders needed a system to account for the constantly changing values of national currencies. Assume a European investor has investment accounts that are all denominated in euros (EUR). Let’s say they purchase shares of a U.S. company through a U.S. exchange using U.S. dollars (USD). This means they are now exposed to exchange rate risk while holding that stock. Exchange rate risk is the threat that the value of the euro will increase in relation to the USD. If this happens, any profits the investor realizes upon selling the stock become less valuable when they are converted back into euros. A speculator who expects the euro to appreciate vs. the dollar could profit by using a derivative that rises in value with the euro. When using derivatives to speculate on the price movement of an underlying asset, the investor does not need to have the actual underlying asset in their portfolio.  Types of derivatives Derivatives today are based on a wide variety of underlying assets and have many uses, even exotic ones. For example, there are derivatives based on weather data, such as the amount of rain or the number of sunny days in a region. There are different types of derivatives that can be used for risk management, speculation, and leveraging a position. The derivatives market continues to grow, expanding with products to fit nearly any need or level of risk tolerance.  Lock and Option Lock products (e.g., futures, forwards, or swaps) bind the respective parties from the outset to the agreed-upon terms over the life of the contract. Option products (e.g., stock options), on the other hand, offer the holder the right, but not the obligation, to buy or sell the underlying asset or security at a specific price on or before the option’s expiration date. The most common derivative types are futures, forwards, swaps, and options.  A futures contract, or simply futures, is an agreement between two parties for the purchase and delivery of an asset at an agreed- upon price at a future date. Futures are standardized contracts that trade on an exchange. Traders use futures to hedge their FUTURES risk or speculate on the price of an underlying asset. The parties involved are obligated to fulfill a commitment to buy or sell the underlying asset  TRADE EXAMPLE Nov. 6, 2024, Company A buys a futures contract for oil at a price of $72.22 per barrel that expires Dec. 19, 2024. The company does this because it needs oil in December and is concerned that the price will rise before the company needs to buy. Buying an oil futures contract hedges the company’s risk because the seller is obligated to deliver oil to Company A for $72.22 per barrel once the contract expires. Assume oil prices rise to $80.00 per barrel by Dec. 19, 2024. Company A can accept delivery of the oil from the seller of the futures contract, but if it no longer needs the oil, it can also sell the contract before expiration and keep the profits.  The outcome…… In this example, both the futures buyer and seller hedge their risk. Company A needed oil in the future and wanted to offset the risk that the price may rise in December with a long position in an oil futures contract. The seller could be an oil company concerned about falling oil prices that wanted to eliminate that risk by selling or shorting a futures contract that fixed the price it would get in December. It is also possible that one or both of the parties are speculators with the opposite opinions about the price of oil in December. In that case, one might benefit from the contract, and one might not.  The profit and the loss The futures contract for West Texas Intermediate (WTI) oil that trades on the CME represents 1,000 barrels of oil. If the price of oil rose from $72.22 to $80 per barrel, the trader with the long position—the buyer—in the futures contract would have profited $7,780 [($80 - $72.22) × 1,000 = $7,780]. The trader with the short position—the seller—in the contract would have a loss of $7,780.  Cash settlement of Futures Not all futures contracts are settled at expiration by delivering the underlying asset. If both parties are traders, it is unlikely that either of them would want to make arrangements for the delivery of a large number of barrels of crude oil. Traders can end their obligation to purchase or deliver the underlying commodity by closing (unwinding) their contract before expiration with an offsetting contract. Many derivatives are, in fact, cash-settled, which means that the gain or loss in the trade is simply an accounting cash flow to the trader’s brokerage account. Futures contracts that are cash-settled include many interest rate futures, stock index futures, and more unusual instruments such as volatility futures or weather futures.  Key takeaways Futures contracts are financial A futures contract allows an derivatives that oblige the buyer investor to speculate on the to purchase some underlying direction of a security, asset (or the seller to sell that commodity, or financial asset) at a predetermined future instrument, either long or short, price and date. using leverage. Futures are also often used to There are tradeable futures hedge the price movement of contracts for almost any the underlying asset to help commodity imaginable, such as prevent losses from unfavorable grain, livestock, energy, price changes. currencies, and even securities.  FORWARDS A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date. A forward contract can be used for hedging or speculation, although its non-standardized nature makes it particularly apt for hedging.  Bit more detail Unlike standard futures contracts, a forward contract can be customized to a commodity, amount, and delivery date. Commodities traded can be grains, precious metals, natural gas, oil, or even poultry. A forward contract settlement can occur on a cash or delivery basis. Forward contracts do not trade on a centralized exchange and are therefore regarded as over-the-counter (OTC) instruments. While their OTC nature makes it easier to customize terms, the lack of a centralized clearinghouse also gives rise to a higher degree of default risk.  An example………. An agricultural producer has two million bushels of corn to sell six months from now and is concerned about a potential decline in the price of corn. Enters into a forward contract to sell two million bushels of corn at a price of $4.30 per bushel in six months, with settlement on a cash basis. In six months, the spot price of corn has three possibilities: It is exactly $4.30 per bushel. In this case, no monies are owed by the producer or financial institution to each other and the contract is closed. It is higher than the contract price, say $5 per bushel. The producer owes the institution $1.4 million, or the difference between the current spot price and the contracted rate of $4.30. It is lower than the contract price, say $3.50 per bushel. The financial institution will pay the producer $1.6 million, or the difference between the contracted rate of $4.30 and the current spot price.  The details of forward contracts are restricted to the buyer and seller—and are not known to the general public— so the size of this market is difficult to estimate although many of the world’s biggest corporations use it to hedge currency and interest rate risks The large size and unregulated nature of the forward contracts market mean that it may be susceptible to a cascading series of defaults in the worst-case scenario. While banks and financial corporations mitigate this risk by being very careful in their choice of counterparty, the possibility of large-scale default does exist. Risks of Another risk that arises from the non-standard nature of forward Forwards contracts is that they are only settled on the settlement date and are not marked-to-market like futures. What if the forward rate specified in the contract diverges widely from the spot rate at the time of settlement? In this case, the financial institution that originated the forward contract is exposed to a greater degree of risk in the event of default or non-settlement by the client than if the contract were marked-to-market regularly.  Forwards in summary A forward contract is a Forward contracts can be customizable derivative tailored to a specific contract between two parties to commodity, amount, and buy or sell an asset at a delivery date. specified price on a future date. For example, forward contracts Forward contracts do not trade can help producers and users of on a centralized exchange and agricultural products hedge are considered over-the-counter against a change in the price of (OTC) instruments. an underlying asset or commodity. Financial institutions that initiate forward contracts are exposed to a greater degree of settlement and default risk compared to contracts that are marked-to-market regularly.  Swaps Two parties exchange the cash flows or liabilities from two different financial instruments. Usually, the principal does not change hands. Each cash flow comprises one leg of the swap. One cash flow is generally fixed, while the other is variable and based on a benchmark interest rate, floating currency exchange rate, or index price. The most common kind of swap is an interest rate swap. Swaps do not trade on typical exchanges, and generally, retail investors do not engage in them. Rather, swaps are transacted over the counter (OTC) They occur primarily between businesses or financial institutions  Currency Swaps In a currency swap, the parties exchange interest and principal payments on debt denominated in different currencies. Cash flows are based on a fixed rate and a variable rate (which is based on the floating currency exchange rate). Unlike with an interest rate swap, the principal is not a notional amount, but it is exchanged along with interest obligations. Currency swaps can take place between countries. For example, China has used swaps with Argentina, helping the latter stabilize its foreign reserves. The U.S. Federal Reserve engaged in an aggressive swap strategy with European central banks during the 2010 European financial crisis to stabilize the euro, which was falling in value due to the Greek debt crisis.  Other types of SWAP Debt-Equity Swaps A debt-equity swap involves the exchange of debt for equity. In the case of a publicly traded company, this would mean bonds for stocks. It is a way for companies to refinance their debt or reallocate their capital structure. Total Return Swaps In a total return swap, the total return from an asset is exchanged for a fixed interest rate. This gives the party paying the fixed-rate exposure to the underlying asset—a stock or an index. For example, an investor could pay a fixed rate to one party in return for the capital appreciation plus dividend payments of a pool of stocks. Credit Default Swap (CDS) A credit default swap (CDS) consists of an agreement by one party to pay the lost principal and interest of a loan to the CDS buyer if a borrower defaults on a loan. Excessive leverage and poor risk management in the CDS market were contributing causes of the 2008 financial crisis.  Swaps in summary A swap is a derivative contract that involves the exchange of cash flows related to a financial security. Interest rate swaps are the most commonly used swaps and usually involve a fixed interest rate and a variable interest rate. Credit default swaps contributed to the causes of the 2008 financial crisis. Institutions evaluate their outlooks for, e.g., interest rate movements, when they consider entering into an interest rate swap. (Word example) Options An options contract is an agreement between two parties for a potential transaction on an underlying security at a preset price, called the strike price, before or on the expiration date. Grants the buyer the right, but not the obligation, to buy or sell a particular asset (like a stock) at a preset price within a given period. As financial markets have grown increasingly complex and volatile, options are used to guard against uncertainty and capitalize on price changes.  Options Options contracts are valued based on the underlying securities. These contracts allow the buyer to buy or sell—depending on the type of contract they hold—the underlying asset at a price set out in the agreement, either within a specific time frame or at the expiration date. The underlying assets include currencies, stocks, indexes, interest rates, exchange-traded funds, and more  Types of contracts There are two types of They can also be sold to In general, call options The buyer of a call option Put buyers, meanwhile, options contracts: puts generate income. can be bought as a has the right, but not the have the right, but not and calls. Both can be leveraged bet on the obligation, to buy the the obligation, to sell the bought to speculate (to appreciation of a stock or number of shares shares at the strike price profit on price changes) index, while put options covered in the contract specified in the contract or hedge exposure (that are purchased to profit at the strike price. is, to insure positions you from price declines. already have or may have).  Types of contract (2) Put option contract: Buyers of put Call option contract: In a call option options often speculate on price transaction, a position is opened declines in the underlying asset when a contract or contracts are and own the right to sell the shares bought from the seller. The seller is at the strike price. If the share price paid a premium to assume the drops below the strike price before obligation of selling shares at the or at expiration, the buyer can sell strike price. The position is called a the shares to the option seller at covered call if the seller holds the the strike price or sell the contract shares to be sold. if the shares are not held in the portfolio.  When and what… When trading volume or volatility is relatively low and the market is trending upward, traders often buy one or more calls since call options tend to appreciate in value as the underlying asset's price rises. Traders tend to buy puts when volume or volatility is relatively low and the market is trending downward since puts increase in value when the market declines. During market downturns, option traders often sell calls, while they sell puts when the market is advancing  American options can be exercised any time before the expiration date of the option, while European options can only be For your exercised on the expiration date or the exercise date. info…….  Options can be an effective tool for hedging as they allow investors to protect investments against downside risk while retaining the possibility of upside gain. Hedging Hedging involves taking an offsetting position in a related security, such as a call or put option. To protect a stock portfolio from a potential downturn you might buy put options for the stocks on the portfolio. If stock prices fall, the put options will increase in value, offsetting the losses in the portfolio.  Because of their inherent leverage, options allow you to control a large amount of a stock or other underlying asset through a relatively small premium. Suppose you expect a company's stock Speculation price will rise and buy call options. If the stock price increases beyond the strike price of the options, you earn a profit that is a multiple of the initial premium paid. Or, if an investor believes a stock's price is about to fall, they might buy put options. A drop in the stock price below the strike price can lead to significant gains relative to the initial premium.  Calls : +ve and -ve Leverage: You can control a larger Time decay: The option's value Call: Buy amount of stock with a smaller erodes as expiration approaches. investment. No ownership rights: No dividends Limited risk: Maximum loss is the or voting rights on the underlying premium paid. stock. Profit potential: Profits can be Requires astute timing: The stock substantial if the stock price rises price must rise above the strike price significantly. before expiration to profit. Unlimited risk: Losses can be Generating income: Earn premium Call: Sell significant if the stock price rises income from selling the option. significantly. Obligation to sell: If the option is Limited profit potential: The exercised, you must sell the stock at maximum profit is the premium the strike price, even if the market received. price is higher.  Puts : +ve and - ve Hedging: Protect against downside risk in Time decay: The option's value erodes as Put: Buy a long stock position. expiration approaches. Profit from falling prices: Profit if the Premium cost: The initial cost of buying stock price falls below the strike price the put option can cut into overall profits. before expiration. Limited risk: The maximum loss is the No ownership rights: No dividends or premium paid. voting rights on the underlying stock. Generating income: Earn premium Limited profit potential: The maximum Put: Sell income from selling the option. profit is the premium received. Profit from stable or rising prices: The Obligation to buy: If the option is option will expire worthless if the stock price exercised, you must buy the stock at the stays above the strike price. strike price, even if the market price is lower. Significant risk if the underlying asset Neutral-to-bullish Outlook: Suitable for falls sharply: Losses can be substantial if investors who think the underlying asset is the stock price falls deeply below the strike stable or will increase. price.  Options are financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at a preset price on or before a specific date. There are two main types of options: call options, which give the holder (buyer) the right to buy the underlying asset, and put options, which give the holder (buyer) the right to sell the underlying asset. Depending on your goals and risk tolerance, options contracts can be used for hedging, speculation, and Options - generating income. The price of an option, known as the premium, is summary affected by the underlying asset's price, the strike price, time until expiration, and market volatility. Options trading carries inherent risks, such as the potential for significant losses if the market moves against your position, and requires a thorough understanding of the mechanics and strategies involved.