Different people have described derivatives differently. Warren Buffett, for one, described them as financial weapons of mass destruction. Martin Mayer has called them instruments that shift the risk to the dumbest guy in the room.
Shailaja and Manoj K Singh
Our friend Jinny thinks that derivatives are like a double-edged sword. You can use the sword to protect yourself but, if you are not careful, you may end up hurting yourself. Let us try to understand how derivative instruments work by joining our friends Jinny and Johnny in their chat:
Johnny: Recently, I heard about one guy selling “flat tyre options” that give you an option of exchanging your flat tyre for a perfectly good one. I don’t know how these derivative products actually work. Do you have any idea?
Jinny: Well, I don’t know what “flat tyre options” you are talking about, but I can definitely tell you how financial derivative products such as futures and options work if you are really interested.
Johnny: Interested? Why not? Maybe I can design my own derivative product if only I can understand how derivatives work.
Jinny: Literally speaking, derivative means something that has been derived from something else. For instance, butter is derived from milk. So, butter is a derivative product of milk. Similarly, derivatives are financial instruments that derive their value from some other underlying financial instruments, such as stocks, bonds, or assets—including loans, currencies and commodities or even abstract variables such as changes in the weather or interest rates.
Derivatives are based on the future value of the underlying financial instruments or assets or variables. For this reason, derivative instruments are used for hedging risk.
Suppose you want to purchase an asset after a month but you are not sure what its price will be then. To hedge the price uncertainties, you purchase a derivative instrument that promises to sell you that asset after one month at a price that is fixed today. This is how derivative instruments help you hedge the price risk.
Johnny: But, I have heard that derivatives themselves are of several kinds. How do different kinds of derivatives operate?
Jinny: We can put derivatives into different classes on the basis of different criteria.
On the basis of their trading mechanism, we can put derivatives into two categories: derivatives traded over the counter (OTC) and derivatives traded on the floor of a stock exchange.
Further, on the basis of the underlying instrument or asset, the derivatives can again be classified into different types.
For instance, in an equity derivative, the underlying instruments are equity instruments. In a forex derivative, they are foreign currencies and in a commodity derivative, they could be different commodities. In this manner, you could have as many kinds of derivative instruments as their underlying assets or instruments.
Johnny: How are derivatives traded over the counter different from derivatives traded on the floors of stock exchanges?
Jinny: OTC derivatives are privately negotiated between parties. They are tailor-made to suit the requirements of the parties involved.
One common example of OTC derivatives is a forward contract. In a forward contract, two parties sit together and decide the contract size, maturity and price.
Derivatives traded on the floor of a stock exchange are like ready-made clothes of universal size. The contract size, maturity, lot size are standardized in the case of exchange-traded derivatives. The settlement of all such derivatives takes place through the stock exchange and hence, the default risk is less.
Exchange-traded derivatives are again of two types: futures and options. There is a third kind of derivative, which we call swaps, that can be traded both privately as well as on the stock exchanges.
Johnny: Ah! futures, options and swaps! I have heard so much about them. But the more I hear, the more I get confused.
Jinny: As I said, futures are standardized contracts that are traded on a stock exchange. The contracts relate to buying or selling the underlying assets or instruments at a specified price at a future, or final settlement, date. The parties have to pay margin money for entering into a futures contract.
On the settlement date, the parties have to settle their obligation either by physical delivery or by cash. In case of physical delivery, actual delivery of the asset or instrument takes place. In the case parties are not interested in taking actual delivery, they can settle their obligation by payment of cash on the basis of the difference between the contracted price and the actual price of the asset on the settlement date. The parties can also offset their positions before the settlement date by entering into an opposite contract.
Suppose, on 1 September, I enter into a futures contract to buy an asset at the future price of Rs100, and the settlement date is 30 September. Suppose, by 20 September, the future price rises to Rs105 and I want to offset my position. How will I do that? I will simply enter into an opposite contract to sell the asset at the prevailing future price. My gain or loss depends upon the rise or fall of the future price of the asset between the two dates.
Jinny and Johnny will continue this chat next week.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them email@example.com