An options contract is nothing but the right to buy or sell something at a specified price within a period of time. The feature of the options contract for a buyer is that, the buyer has the right to buy, but he may choose to buy or may even choose to cancel the contract. Hence the buyers maximum loss is only the initial amount that was paid to gain the rights. Unlike buyers, the options contracts for sellers is an obligation. If a seller enters into an agreement, he has to deliver the asset on the specified date and the price agreed upon. Thus the loss for a seller could be much worse.
Terminologies
1. CALL and PUT
The right to buy is called a "CALL" option while the right to sell is called a "PUT" option.
right to buy - CALL (learning bc - buy call)
right to sell - PUT
Please note that an option is only a right to do something. It is not an obligation to carry out the action. For a buyer it is only a right and not an obligation, but for a seller it is an obligation.
For Example, you want to buy Gold. You form an options contract with a Gold merchant to buy 1000 grams of Gold at the rate of say Rs. 1000/- per gram of gold on December 1st 2008. The total value of the contract would sum up to 10,00,000/- (10 lacs) As part of getting into the contract you make an initial payment of say 2% of the contract value to the merchant. You make a payment of Rs. 20 thousand (Rs. 20,000/-) and the contract gets formed. Now you are the buyer and the merchant is the seller.
Change of Price of Asset
Now take the above example on gold.
1. Assuming on 1st December the price of gold is Rs. 1050/- per gram, then to buy thousand grams of gold you would need Rs. 10,50,000/- rupees which is Rs. 50,000/- more than your options contract. Hence if you exercise your right to buy, you stand to make a profit of Rs. 50,000/- At the same time, the seller has an obligation since he has agreed on the contract and he has to sell the gold to you at a loss of Rs. 50,000/- when compared to the market rate.
2. Assuming on 1st December the price of gold is Rs. 950/- per gram, then to buy thousand grams of gold you would need Rs. 9,50,000/- which is Rs. 50,000/- less than your options contract. Hence if you exercise your right to buy, you stand to lose Rs. 50,000/- You can buy the same quantity of gold in the market at a lesser price. Hence you can choose to let your contract expire and limit your losses to only Rs. 20,000/- The Seller on the other hand does not make any transaction but still stands to keep the Rs. 20,000/- you paid him to form the contract.
In above example 1 thing is clear, that why option is called derivative because option is a contract that deals with an underlying asset like gold, property, stock the value of which changes.
Another point we get is when you buy an option, you have a right but not an obligation to do something. You can always let the expiration date go by, at which point the option becomes worthless. If this happens, you lose 100% of your investment (the initial one), which is the money you used to pay for the option.
The initial 2% charged is because the buyer don't give full money to the seller in advance. This is like interest or security.
2. STRIKE / EXERCISE PRICE, OPTION PREMIUM, EXPIRY DATE, SERIES
This 1000 rupees per gram that you agreed upon with the merchant is called the "STRIKE OR EXERCISE" Price.
The initial deposit of Rs. 20,000/- you paid him is called the "Option premium".
EXPIRY OR EXPIRATION MONTH = when the option contract terminates
SERIES = expiration month and exercise price
We will cover more terminology as we go through this tutorial.
Partcipants in an Options market:
1. Buyers of Calls
2. Sellers of Calls
3. Buyers of Puts
4. Sellers of Puts
People who buy options are called "HOLDERS" and (learning way bh of bhu )
those who sell options are called "WRITERS"
Eg. in case of stock market.
Buyers of calls hope that the stock will increase substantially before the option expires. Buyers of puts hope that the price of the stock will fall before the option expires.
Call Holders and Put Holders (The Buyers) are not obligated to buy or sell. They have the right to do so if they wish. Similarly Call writers and Put Writers (The Sellers) are obliged to buy or sell. This means that they need to buy or sell if the Call holder decides to exercise his right to buy.
Characteristics of Options Contracts:
1. Unlike other derivative products that are price fixing contracts, options are price insurance type of contracts
2. Options have been basically OTC products. But of late, due to its popularity, exchange traded options are also being widely used.
3. The options are very favourable to the Holders or the Buyers.
Widely used terms in Options contracts:
In-the-Money - An ITM option is one that would lead to a positive cash flow to the holder if it were exercised immediately. For e.g., If you have an options contract to buy shares of XYZ limited at Rs. 100/- per share and it is currently trading at Rs. 120/- per share then your options contract is said to be In the Money.
At-the-Money - An ATM option is when the prevailing price of the asset and your option price are more or less same.
Out-of-the-Money - An OTM option is when the prevailing price of the asset is lesser than the option price.
An Example call Option with respect to the Share Market:
You buy 10 call options for the company XYZ pvt ltd, at the strike price of Rs. 325/- at a premium of Rs. 10 per option. The option is valid till 30th Oct 2008.
Two things can happen here:
1. You can make a profit:
Say on the date of expiry the share of XYZ pvt ltd is trading at Rs. 380/- per share, then you can opt to exercise your call option. Hence you would be getting 10 shares of XYZ ltd at Rs. 325/- which you can sell at Rs. 380/-
Your Input cost per share = 325
Premium per share = 10
Market value during Selling = 380
Your Profit per share = 380 - (325+10) = Rs. 45 /-
Net Profit = Rs. 450/-
Here Rs. 325 is the Strike price and Rs. 380 is the spot price.
2. You can incur a Loss:
Say on the date of expiry the shares of XYZ pvt ltd is trading at Rs. 275/- per share, then you can opt to let the contract expire. Since you are the buyer or the call holder you can opt to either buy or let the contract expire. Since the share is available in the market at a lesser price than the strike price, it is not wise to exercise the option. Hence you ignore it.
Your input cost = Rs. 10/- (The premium you paid per option)
Loss incurred = Rs. 100/- (Because you do not make any other payment apart from the premium)
Loss you would have incurred if you had exercised the option:
Cost per share = 325
Premium per share = 10
Market value during selling = 280
Your loss per share = (325+10) - 280 = Rs. 55/-
Net Loss: Rs. 550/-
Incurring a loss of Rs. 100/- is better than incurring a loss of Rs. 550/- hence your decision of letting the contract expire was a wise decision.
An Example Put Option with respect to the Share Market:
You buy 10 put options for the company XYZ pvt ltd, at the strike price of Rs. 300 per share at a premium of Rs. 10 per option. The option is valid till 30th Oct 2008.
Two things can happen here:
1. You can make a profit:
Say on the date of expiry, the shares of XYZ is trading at Rs. 265/- per share, then you can opt to exercise your contract. You can buy 10 shares of XYZ from the market and then sell your shares to the option writer since he has an obligation to buy if you intend to sell.
Your premium = 10
Your input cost per share = 265
Price at which the Put option is exercise = 300
Profit per share = 300 - (265 + 10) = 25
Net Profit = Rs. 250/-
2. You can make a Loss:
Say on the date of expiry, the shares of XYZ is trading at Rs. 325/- per share, then you can opt to let the contract expire. Since the share is trading at a price more than the option price, you can choose to let the contract expire.
Your premium = 10
Loss incurred = Rs. 100/- (The premium paid)
Even in this case, this loss would be compensated by the fact that you can sell off the shares that you have in the market at a higher price than the option strike price.
Effect of markets
ETD markets
Options specification and nomenclature is set by the exchange at the time of listing. In the case of equity options, the specifications are only changed by the corporate actions.
OTC markets (Over the counter)
The terms of OTC options are negotiated between the buyer and the seller and are therefore customized.
# American form = exercisable on any business day during its life
# European form = exercisable only at the end of its life
# Exercise of equity options = physical settlement in trading lots
# Exercise of index options = cash settlement in exchange set lots
# Exercise of currency options = cash settlement in country of underlying currency
# Exercise of interest rate options = deliverable set by exchange
Showing posts with label ETD. Show all posts
Showing posts with label ETD. Show all posts
Monday, 26 July 2010
Saturday, 17 July 2010
The Secondary Market of bonds
The secondary market is the market for bonds that have already been issued on the primary market. On the secondary market, investors trade bonds with other investors through financial professionals. The investors who sell the bonds receive the proceeds, minus fees or commission payable to banks/brokers that facilitate the transaction.
Brokers and banks may purchase large numbers of bonds in the primary market and then sell them to investors in the secondary market. A bond may change hands a number of times on the secondary market before it reaches maturity.
The over-the-counter (OTC) market is the most common method of trading bonds on the secondary market. OTC trading refers to the buying and selling of bonds outside of an organized exchange. The market is made up of banks and brokerages that buy and sell bonds over the phone or electronically.
Many bonds are listed on a stock exchange, even though most trading is carried out on the OTC market. Stock exchanges are more transparent than OTC markets because prices and trading volumes are easily observable in exchange-traded markets. Despite this, exchange-traded volumes are still negligible compared to volumes on the OTC market.
The secondary market is the market for bonds that have already been issued on the primary market. The secondary market gives a price to bonds so that they can be sold before maturity.
On the secondary market, investors trade bonds with other investors through financial professionals. The original bond issuers normally play no part in the transaction at this stage. The investors who sell the bonds get the proceeds, minus fees or commission payable to the financial professionals who facilitate the transaction.
People Involved
It involves following people:
Trading Systems
The availability of automated trading systems and securities information systems has greatly enhanced bond trading. It accelerates trading and increases transparency for all market participants. In the US alone, bonds can be traded on over 80 trading systems.
These are the following:
Settlement and Taxation
Settlement
On the secondary market, settlement of trade usually occurs through domestic or international electronic clearing systems, such as Euroclear. Typically, settlement takes three business days (T+3), though it is sometimes shorter.
Taxation
Many countries charge a withholding tax on interest income and capital gains tax on capital gains from bonds.
Where a bilateral tax treaty exists between the issuer's country and the investor's country, the level of tax charged will be limited to the treaty amount. More and more countries are exempting non-residents from such taxes.
Brokers and banks may purchase large numbers of bonds in the primary market and then sell them to investors in the secondary market. A bond may change hands a number of times on the secondary market before it reaches maturity.
The over-the-counter (OTC) market is the most common method of trading bonds on the secondary market. OTC trading refers to the buying and selling of bonds outside of an organized exchange. The market is made up of banks and brokerages that buy and sell bonds over the phone or electronically.
Many bonds are listed on a stock exchange, even though most trading is carried out on the OTC market. Stock exchanges are more transparent than OTC markets because prices and trading volumes are easily observable in exchange-traded markets. Despite this, exchange-traded volumes are still negligible compared to volumes on the OTC market.
The secondary market is the market for bonds that have already been issued on the primary market. The secondary market gives a price to bonds so that they can be sold before maturity.
On the secondary market, investors trade bonds with other investors through financial professionals. The original bond issuers normally play no part in the transaction at this stage. The investors who sell the bonds get the proceeds, minus fees or commission payable to the financial professionals who facilitate the transaction.
People Involved
It involves following people:
- Broker
- Dealers
- Market Makers
- Inter-dealer broker
- Broker-dealer
- OTC - most common way
- ETD
Trading Systems
The availability of automated trading systems and securities information systems has greatly enhanced bond trading. It accelerates trading and increases transparency for all market participants. In the US alone, bonds can be traded on over 80 trading systems.
These are the following:
- Tradeweb
- E-speed
- Eurex bonds
- NYSE bonds
Settlement and Taxation
Settlement
On the secondary market, settlement of trade usually occurs through domestic or international electronic clearing systems, such as Euroclear. Typically, settlement takes three business days (T+3), though it is sometimes shorter.
Taxation
Many countries charge a withholding tax on interest income and capital gains tax on capital gains from bonds.
Where a bilateral tax treaty exists between the issuer's country and the investor's country, the level of tax charged will be limited to the treaty amount. More and more countries are exempting non-residents from such taxes.
Tuesday, 13 July 2010
Trading Locations - Exchanges and OTC markets
Trading Locations - Exchanges
In the case of exchanges, there has historically been a central physical location where trading has taken place. For instance, for many years, futures exchanges in Chicago conducted all business via 'open-outcry' transactions conducted between agents located in 'trading pits'. The New York Stock Exchange (NYSE) has a trading floor on Wall Street where a continuous auction operated by floor members sets prices for the stocks traded on the exchange.
However, this has changed dramatically in recent years. Modern exchanges, particularly those outside the United States, are now predominantly electronic, 'virtual' exchanges – traders do not need to be physically located in a particular place. Most major European futures exchanges are electronic, and there is no physical trading center for the London Stock Exchange; instead market-making firms conduct business through the utilization of electronic networks and messaging.
Some exchanges have side-by-side (SBS) trading; products can be traded either physically or else using an electronic network. It is noticeable that in nearly all these cases, electronic volume eventually supersedes that conducted physically.
Trading Locations - OTC
Since an OTC trade is generally a matter of bilateral negotiation, parties can be located anywhere so long as they can contact each other. A client in Europe might conduct business with a financial institution in the United States. For the most part, trades are negotiated on the telephone and transactions are finalized by the simple process of verbal agreement. Most institutions will record telephone conversations in order to clarify any post-trade disagreements.
In some markets, telephone transactions are being replaced by electronic networks. A customer who wishes to transact in foreign exchange, for instance, need not necessarily call one or many relationship banks in order to obtain a quotation. They may be able to access a number of prices using an electronic marketplace on the Internet, and transact simply through 'pointing and clicking'. For complex products, where sales advice is useful or even obligatory, it may still be necessary to contact an institution.
Global Spread of Markets
Electronic markets, mergers between exchanges, and the increasing ease of international communication have all increased the ease of overseas investing. Cross-border capital flows are ever-increasing; USD 10 trillion is one estimate of such flows in 2007, estimated to be triple the 1997 amount. 20% of all equities and 25% of all bonds are probably held offshore.* As agents make choices between transactions across asset classes and jurisdictions, they increasingly focus on the relative values offered in different markets.
Furthermore, market observers have identified a tendency for market values in different markets to be closely correlated, as the 'risk appetite' of international investors changes. When the 'risk appetite' is high, investors are more willing to purchase assets that are perceived as being 'riskier'; they are happier taking on credit risk, or investing in less-developed markets. If the risk appetite falls, there is a 'flight to quality'; the prices of 'safe' assets, such as government bonds, increase relative to these riskier assets. Consequently there is an association between price changes in quite different markets; a general fall in the level of a less-developed stock index might be associated with a fall in the level of corporate bonds.
Many investment banks attempt to measure this association through various 'risk appetite indexes'. However, correlation and association have historically proven difficult to quantify, though the qualitative issues seem clear-cut. There have been a number of occasions in the past when previously distinct markets have exhibited a clear correlation in price behavior.
Exchange traded (ETD) markets and Over the counter (OTC) markets
Exchange Traded Market
In this Market, a central organization(the exchange) outlines the rules and regulation surrounding the financial transaction. Every transaction needs to be reported to the exchange.
Most common type of exchange are stock exchange and future exchange.
Egs
Although the foreign exchange forward market is predominantly OTC, a futures contract which references forward foreign exchange rates would be an exchange-traded product.
What do we mean by exchange?
What this means is that while you may be buying for example 100 shares of Google stock at the same time someone else is selling those shares, you do not buy those shares directly from the seller but instead from the exchange.
Advantage
The fact that the exchange stands on the other side of all trades in exchange traded markets is one of their key advantages as this removes counterparty risk, or the chance that the person who you are trading with will default on their obligations relating to the trade.
A second key advantage of exchange traded markets is that as all trades flow through one central place, the price that is quoted for a particular instrument is always the same regardless of the size or sophistication of the person or entity making the trade. This in theory should create a more level playing field which can be an advantage to the smaller and less sophisticated trader.
Lastly, because all firms that offer exchange traded products must be members and register with the exchange, there is greater regulatory oversight which can make exchange traded markets a much safer place for individuals to trade.
Disadvantage
The downside that is often cited about exchange traded markets is cost. As the firms who offer exchange traded products must meet high regulatory requirements to do so, this makes it more costly for them to offer these products, a cost that is inevitably passed along to the end user. Secondly, as all trades in exchange traded products must flow through the exchange this gives these for profit entities immense power when setting things such as exchange fees which can also increase transaction costs for the end user.
Over the Counter(OTC) Market
In this case financial transaction are consummated through private negotiation between counterparts.
Eg. Govt bonds,Corporate bonds,short term debt securities,interbank deposits syndicated loans,interest rate swaps
Eg. of both: Most govt bond trading is OTC. But many bonds are also listed on stock exchange.
Advantage
The biggest advantage to over the counter markets is that because there is no centralized exchange and little regulation, you have heavy competition between different providers to attract the most traders and trading volume to their firm. This being the case transaction costs are normally lower in over the counter markets when compared to similar products that trade on an exchange.
As there is no centralized exchange the firms that make prices in the instrument that is trading over the counter can make whatever price they want, and the quality of execution varies from firm to firm for the same instrument. While this is less of a problem in liquid markets such as FX where there are multiple price reference sources, it can be a problem in less highly traded instruments.
Disadvantage
While the lack of regulation can be seen as an advantage in the above sense it can also be seen as a disadvantage, as the low barriers to entry and lack of heavy oversight also make it easier for firms offering trading to operate in a dishonest or fraudulent way.
Lastly, as there is no centralized exchange the firm that you trade with when you trade in an over the counter market like forex is the counterparty to your trade, so if something happens to that firm you are in danger of loosing not only the trades you have with that firm but also your account balance.
It is for these reasons that there is so much focus among forex traders as to which firm to trade with, with special attention being paid to the financial stability of the firm and the execution that they provide.
See the trading locations of Exchanges and OTC markets.
In this Market, a central organization(the exchange) outlines the rules and regulation surrounding the financial transaction. Every transaction needs to be reported to the exchange.
Most common type of exchange are stock exchange and future exchange.
Egs
Although the foreign exchange forward market is predominantly OTC, a futures contract which references forward foreign exchange rates would be an exchange-traded product.
What do we mean by exchange?
What this means is that while you may be buying for example 100 shares of Google stock at the same time someone else is selling those shares, you do not buy those shares directly from the seller but instead from the exchange.
Advantage
The fact that the exchange stands on the other side of all trades in exchange traded markets is one of their key advantages as this removes counterparty risk, or the chance that the person who you are trading with will default on their obligations relating to the trade.
A second key advantage of exchange traded markets is that as all trades flow through one central place, the price that is quoted for a particular instrument is always the same regardless of the size or sophistication of the person or entity making the trade. This in theory should create a more level playing field which can be an advantage to the smaller and less sophisticated trader.
Lastly, because all firms that offer exchange traded products must be members and register with the exchange, there is greater regulatory oversight which can make exchange traded markets a much safer place for individuals to trade.
Disadvantage
The downside that is often cited about exchange traded markets is cost. As the firms who offer exchange traded products must meet high regulatory requirements to do so, this makes it more costly for them to offer these products, a cost that is inevitably passed along to the end user. Secondly, as all trades in exchange traded products must flow through the exchange this gives these for profit entities immense power when setting things such as exchange fees which can also increase transaction costs for the end user.
Over the Counter(OTC) Market
In this case financial transaction are consummated through private negotiation between counterparts.
Eg. Govt bonds,Corporate bonds,short term debt securities,interbank deposits syndicated loans,interest rate swaps
Eg. of both: Most govt bond trading is OTC. But many bonds are also listed on stock exchange.
Advantage
The biggest advantage to over the counter markets is that because there is no centralized exchange and little regulation, you have heavy competition between different providers to attract the most traders and trading volume to their firm. This being the case transaction costs are normally lower in over the counter markets when compared to similar products that trade on an exchange.
As there is no centralized exchange the firms that make prices in the instrument that is trading over the counter can make whatever price they want, and the quality of execution varies from firm to firm for the same instrument. While this is less of a problem in liquid markets such as FX where there are multiple price reference sources, it can be a problem in less highly traded instruments.
Disadvantage
While the lack of regulation can be seen as an advantage in the above sense it can also be seen as a disadvantage, as the low barriers to entry and lack of heavy oversight also make it easier for firms offering trading to operate in a dishonest or fraudulent way.
Lastly, as there is no centralized exchange the firm that you trade with when you trade in an over the counter market like forex is the counterparty to your trade, so if something happens to that firm you are in danger of loosing not only the trades you have with that firm but also your account balance.
It is for these reasons that there is so much focus among forex traders as to which firm to trade with, with special attention being paid to the financial stability of the firm and the execution that they provide.
See the trading locations of Exchanges and OTC markets.
Thursday, 8 July 2010
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.
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.
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