Derivatives and its types

A derivative is the financial contract which derives its value from the performance of an
underlying asset. This underlying asset can be commodities, precious metals, currency,
bonds, stocks, stocks indices on which the price of the derivative is based. Derivatives are the
instruments which are used to hedge the risk against adverse price fluctuation as well as can
be used for speculative purposes.

Types of derivatives

The most common types of derivatives are forwards, futures, swaps and options.

Forward contracts - Forward contracts are a means to hedge against sharp fluctuation in
prices especially in commodity and currency market. It is a non-standardised contract which
is based on the private agreement between two parties. It deals with the buying and selling of
the asset or product for a future date at the prices agreed upon on the date of the contract.
Suppose that Robert wants to buy an asset a year from now. At the same time, suppose that
Adam wants to sell his asset worth $200,000 a year from now. Both parties could enter into a
forward contract with each other. Suppose that they both agree on the sale price in one year's
time of $210,000. Robert as he is buying the underlying is said to have entered a long
forward contract and Adam will have the short forward contract.
At the end of one year, suppose that the current market valuation of Adams asset is $220,000
even Then, Adam is obliged to sell to Robert for only $210,000, Robert will make a profit of
$10,000. Robert has made the difference in profit. In contrast, Adam has made a potential
loss of $10,000.
Thus forward contract is in contrast to the spot contract which is used for trading in
commodities and financial instruments for cash on immediate delivery. The rate quoted for
spot settlement is called as spot rate and date of settlement is known as value date. Spot
contract is valid for settlement up to two working date after the trade date. Spot market is also
known as cash market or physical market.
Future contracts- Future contract is a standardised contract which is traded on the exchange.
It is an agreement between two parties to buy or sell a specified quantity of security,
commodity or a foreign exchange at a fixed time in future at an agreed price. Transaction
costs of future contracts trading are very small as it is standardised in nature.
Futures trading is organised on a regular basis and default risks are reduced. Settlement on
future contracts are made at the end of each day in a daily settlement basis with a practice
called marking to the market and this process continues till the maturity date. It means that
every day, futures investors must pay for any losses and receive any gains from the days
price movements.
For example suppose Robert and Adam is interested in the trading of 100 shares of Tesco
Company, each share having the value of $50. Robert wants to purchase the shares and Adam
wants to sell that a year from now. The total value of 100 shares is $5000. Both enter in the
future contract through which they decide the settlement of shares at the predetermined price
suppose $5050 at a future date. The marking to the market or we can say that profits or losses
of future contract are settled on a daily basis till the maturity date. At the maturity date, future
contract will close by taking delivery or with an off-setting trade. Thus future contract reduce
the default risk.

Comparison of futures and forwards contracts

Future and forward contracts are both used for securities, commodities and currencies
trading. Both have to settle at the future date and both are considered good derivative trading
methods.

The distinction between forward and future contracts are given below-

Forward Contracts Future Contracts
Size of the contract decided by buyer and
seller with mutual agreement (Non
standardise)
It is standardised by nature
It is self regulating It is regulated by the authority
No margin is required Margins are to be paid by both buyer and
seller
Counterparty risk is there No Risk
Contract price is same till maturity It changes everyday
Traded over the counter OTC Traded on the exchange
Settlement on due date Settlement on daily basis
It has no liquidity It is highly liquid

Both forward contracts and futures contracts have their own advantages and disadvantages.

Swaps - Swap is an agreement for exchanging of one set of rights or obligations for another
set of right or obligation. These are the private agreement between the two parties for
exchange of cash flow in future. The objective of swaps is to hedge against risk and
uncertainty. It provides real economic advantage to both the parties entered in the swap.

Types of Swaps: Swaps are of following types

Interest rate swaps
Fixed rate currency swaps
Cross currency interest rate swaps
Basis swaps

Interest Rate Swaps - Interest rate swaps is the exchange of a fixed rate loan to a floating
rate loan or we can say that it is the mutual transfer of interest rate streams without
transferring underlying debts.
Suppose there are two parties in which one party has an obligation to pay a fixed rate of
interest on a bond and other party has to pay a floating rate of interest on a bond. Now they
want to swap their interest rate floating with fixed interest rate and fixed with the floating
interest rate. Principal amount should be same in the case of both parties as principal amount
is not swapped; only interest rate payment is swapped. Both parties should gain the benefit of
swaps and the gain will be in the form of lower costs.

Fixed rate currency swaps - Fixed rate currency swap is an agreement between two parties
to exchange interest rate or principal payments contracted in one currency for payment in the
different currency for the same value calculated as per the schedule. We have to agree upon
initial exchange rate for principal and interest as well as future exchange rate for principal
and interest.

Suppose Party A has borrowed in UK Pound as he is comfortable to borrow this but the party
require money in US dollars. Similarly there is another party that can borrow in US dollars.
So in this case the party B can give dollars to party A. Now party A has to pay in dollars and
party B has to pay in Pound. If these parties does not have inflows of these currencies than
they have to hedge these payments through forward exchange markets.

Cross currency interest rate swaps: This instrument is used to swap principal and interest
rate of one currency with similar amount of principal and interest of different currency. It
requires an intermediary to accomplish this task.

Suppose an American company wants some Australian dollars but it is not easy for him to go
to Australian market and raise fund, instead American company can go in its own country
and raise money. Now American company has to find one another party in Australia who is
in need of US dollars and can give Australian dollars as it is very easy for Australian
company to raise Australian dollars from its own country. Now both the companies can swap
these principal, interest as well as currency and can be benefited from this.

Basis Swaps: In Basis rate swap we swap the basis rate like LIBOR with market interest rate
like US Treasury bill or Commercial paper.

For example a company lends money to a person at floating rate based on LIBOR but borrow
money on Treasury bill rate. So to hedge this difference the company goes for basis swap
where they exchange T-bill rate with LIBOR rate.



Options: An option is a contract that gives right to buyer but not the obligation to execute the
trade means sell or buy the underlying product or asset on a given date. An option is traded
just like a stock like equity on exchange.

Suppose a stock is currently being sold at 100 and the investor pays 20 for the right buy with
an obligation to do so of one share for 120 at the year-end. If the stock price is say 150 when
the option matures, the investor makes a profit of 30 by buying the stock at the contracted
price of 120. On the contrary if the price has remained at 100, he will choose not to exercise
the option, by which he restricts his loss to 20 that he paid to buy the option. If he had used a
forward contract or futures contract, he would have been obliged to buy it at 120 the
contracted price.

Here the expiry date in the options refers to the specified date after which the contract no
longer is considered valid. The price specified in the contract is known as the exercise price
or the strike price.

Types of options: There are two types of Options, Call and Put.

Call Option: It gives the holder the right but not the obligation to buy at a specific price
within a given period of time. It is called so because the owner has the right to buy the stock
from the seller. It is also called an option because the owner of the call option has the right,
but not the obligation to buy the stock at the strike price.

Let say for example the current price of Xyz company stock is $45 per share, and investor Mr
A expects it will go up significantly. Mr A buys a call contract for 100 shares of Xyz
Company from Mr B, who is the call writer/seller. The strike price for the contract is $50 per
share, and Mr A pays a premium up front of $5 per share, or $500 total. If Xyz Company
does not go up, and Mr A does not exercise the contract, then Mr A has lost $500. But xyz
company stock subsequently goes up to $60 per share before the contract expires. Mr A
exercises the call option by buying 100 shares of Xyz Company from Mr B for a total of
$5,000. Mr A then sells the stock on the market at market price for a total of $6,000. Mr A
has paid a $500 contract premium plus a stock cost of $5,000, for a total of $5,500. He has
earned back $6,000, yielding a net profit of $500.


Put Option: It gives the holder the right but not the obligation to sell at a specific price
within a given period of time. It is called so because the owner has the right to sell the stock
to the buyer. It is also called an option because the owner of the put option has the right, but
not the obligation to sell the stock at the strike price.

Lets see this: Suppose the stock of TESCO is trading at $40. A put option contract with a
strike price of $40 expiring in a month's time is being priced at $2. You strongly believe that
TESCO stock will drop sharply in the coming weeks after their earnings report. So you paid
$200 to purchase a single $40 TESCO put option covering 100 shares. Say you were spot on
and the price of TESCO stock plunges to $30 after the company reported weak earnings and
lowered its earnings guidance for the next quarter. With this crash in the underlying stock
price, your put buying strategy will result in a profit of $800. If you were to exercise your put
option after earnings, you invoke your right to sell 100 shares of TESCO stock at $40 each.
Although you don't own any share of Tesco at this time, you can easily go to the open market
to buy 100 shares at only $30 a share and sell them immediately for $40 per share. This gives
you a profit of $10 per share. Since each put option contract covers 100 shares, the total
amount you will receive from the exercise is $1000. As you had paid $200 to purchase this
put option, your net profit for the entire trade is $800.