Derivatives

We would have heard a lot about Derivatives & Derivatives Trading. But not many of us are very sure about what a Derivative is. This article is an attempt to help you learn about Derivatives.

The word 'Derivative' in Financial terms is similar to the word Derivative in Mathematics. In Maths, a Derivative refers to a value or a variable that has been derived from another variable. Similarly a Financial Derivative is something that is derived out of the market of some other market product. Hence, the Derivatives market cannot stand alone. It has to depend on a commodity or an asset from which it is derived. The price of a derivative instrument is dependent on the value of the asset from which it is derived. The underlying asset can be anything like stocks, commodities, stock indices, currencies, interest rates etc.

A derivative instrument derives its value from the market levels of observed simple assets or transactions.
Broadly speaking derivatives are divided into :
1. Forwards / futures
2. Options
3. Swaps

Need of Derivative
Having invested or borrowed funds, agents wish to manage the risks. Simply reversing an initial transaction to avoid such risks may be an excessively coarse, expensive, or impossible action. Furthermore, some assets generate multiple risks; the value of a corporate bond is affected by the issuer's credit worthiness as well as the level of interest rates. A purchaser may be comfortable with the interest rate risk, but not with the credit risk. There is also the problem of future risks; an agent may know today that there is a need to purchase an asset at a future point in time. An estimate can be made of the future cost, based on today's price, but would it not be easier to enter into a transaction today that fixes a price for the future?
As you know, the financial markets come with a very high degree of risk/volatility. By using the derivative products, it is possible for us to partly or fully reduce the risk and to reduce the impact of fluctuations in the asset prices.

Examples
Let me explain how derivatives are used with a real time example...

Say, you go to an electronics shop to buy a TV. After searching around you decide on a model which costs Rs. 25000/-. The shop owner says that he would be able to deliver the TV to your house in one week if you place an order with a small initial amount today. Once the shop owner delivers the TV you are expected to pay the full amount. This is effectively a "Forward" contract where you are agreeing to the terms of delivery and a payment in a future date.

Say, I go to another electronics shop to buy a TV. After searching around I decide on a model that costs Rs. 26000/- Though I like the model I am not too sure if this is the best model for me and at the same time I am predicting the price of TV sets to come down in one week. Along with this I am also worried that if I do not buy this TV, somebody else may buy it. Thus, I talk to the salesman to put aside this TV for two weeks so that I can arrange cash and come for purchase. The salesman in return asks for a small non refundable deposit which I pay to block the TV in my name. If the price of the TV falls then I may not opt to buy the same TV but if I want I can always walk in to the shop after a few days make the payment and take the TV. This is effectively an "Options" contract, wherein I have the option of executing it at my will and wish. The shop owner took a non refundable deposit, which is to compensate for the few days that he may have to hold on to his item without selling it. Even if I do not go to buy the TV he would have made a meager profit.


The Important Categories of Derivatives:

The Derivative products can be categorized into the following main types:

1. Forwards
2. Futures
3. Options
4. Swaps
5. Warrants and
6. Leaps & Baskets

These categories have been explained here also but you can get insight of these by clicking on them.


The Spread of Derivatives

The basic principles of forwards, options, and swaps can be easily extended - derivative instruments cover multiple asset classes in many different geographic locations. As new markets develop, so too new derivatives are manufactured. For instance, in the realm of credit, derivatives exist which allow agents to express views on the creditworthiness of individual entities without necessarily purchasing bonds issued by them or entering into a lending agreement with them.

The evolution of derivatives represents a powerful addition to the armory of risk managers; derivatives allow individual risks to be disentangled, monitored, and controlled, as appropriate. However, the flipside of this undoubted benefit is an increase in the potential for mismanaged positions. Instruments such as futures contracts and options allow much greater leverage than traditional instruments. Furthermore, many derivatives are complicated instruments, and in some cases contracts are idiosyncratic and secretive. It can be difficult to monitor the value of positions, and historically certain agents have entered into transactions without fully understanding their nature. This has led to some well-publicized 'scandals', and there is considerable regulatory unease at the possibility of one single incident leading to losses at multiple different counterparties, and thence to subsequent market paralysis.

Use of Derivatives:
1. Hedging



Types of Derivatives:

1. OTC (Over The Counter) OTC Derivatives are contracts that are traded/negotiated directly between the contracting parties. The OTC Derivative market is the largest market for derivatives and it is also the most unregulated. There is always an inherent risk of either of the parties not honouring the agreement.

2. ETD (Exchange Traded Derivatives) ETD are those that are traded via regulated/specialized trading exchanges. A derivative exchange acts as the intermediary for all transactions and requires an initial margin to be put up by both the parties of the trade to serve as a guarantee. In India NSE is one of the largest ETD exchange.

Problems with Derivatives:

1. Possibility of Huge Losses - The unregulated use of Derivatives can result in huge losses due to the use of Leverage or Borrowing. It is a well known fact that Derivatives allow investors to gain huge sums of money from small movements in the underlying asset's price. However, investors can lose huge amounts of money if the asset moves in the opposite direction. There have been a lot of instances where investors have lost significant amounts of money due to Derivatives.

2. Counterparty Risk - This is the risk that arises if either of the contracting parties fails to honour his end of the contract. This is very common in OTC Derivative products.

3. Posing high risk to small/inexperienced investors - Since the Derivative markets give an opportunity for an individual to earn huge profits, its often lucrative to small/inexperienced investors as well. Speculation in the Derivatives market requires great knowledge of the market and the future price movements on the asset over which the derivative is formed to ensure profit. This is the reason why small investors are generally advised to stay away from them...

There are a large number of Derivative categories. Covering all that in this article would make this too big to read. Hence I would be posting a new article that explains only about those categories.