In the world of
finance, derivatives are instruments where the
performance is based on the behaviour of the price of an
underlying asset.
A derivative is a contract between a pair of counterparties, due to be executed on some future date, apart from options, where the execution (exercise) is optional.
The Underlying
The underlying can be one of the following physical assets:
The underlying can also be something non-physical, which will always be cash settled:
The underlying can sometimes itself be a derivative. You can have
options on
futures
Types of derivative
- futures
Futures are an agreement to trade an underlying asset at a future date, based on today's price. Futures are exchange traded derivatives, and require payments of margin. Expiry of futures contracts happens on a 3 monthly cycle, usually March, June, September and December.
- Forwards
Forwards are an OTC equivalent of futures. As such, the issuing bank can be flexible, making a tailor made contract. However, there is the need to provide collateral, and/or credit references. One popular type of forward is the forward rate agreement, or FRA, offering forwards on interest rates.
- Options
Options are concerned with buying and selling the right to buy or sell an underlying. The right to buy is called a call option, and the right to sell is called a put option. Each option has two counterparties, the buyer of the option, the long party, and the seller (writer), the short party.
There are four combinations:
- buying the right to buy. Long on call.
- selling the right to buy. Short on call.
- buying the right to sell. Long on put.
- selling the right to sell. Short on put.
In exchange for the options contract, the long party pays a premium to the short party, much in the manner of insurance. The short party is the one which is exposed to the risk, as Nick Leeson demonstrated spectacularly.
Options are traded both OTC and on stock exchanges.
Swaps
Similar to a playground scenario, a swap involves the exchange between counterparties of one underlying for another underlying. An everyday example of a swap transaction is exchanging a variable rate property mortgage for a fixed rate mortgage.
Swaps are usually OTC derivatives. Sometimes they involve currencies, for instance USD may have a different exposure to risks than EUR. Also popular are interest rate swaps.
What derivatives are used for
Contrary to popular belief, derivatives are most commonly used in
risk management,
hedging, i.e. reducing the exposure to risk. We have much to thank the press for in giving a bad name to derivatives trading and markets. It is comparable to the equally fallacious argument "
The insurance company never pays up". If this were the case, the insurance company would not be in business.
However, derivatives can also be used for speculation, as Enron have demonstrated. Many countries require financial insitutions taking risks to account for their transactions on a daily basis, and to put hedging in place for risky transactions - as a legal requirement.
Source: Mastering Derivatives Markets - Francesca Taylor. Prentice Hall