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Derivatives: Meaning of various types of derivatives and their uses

Derivatives: Meaning of various types of derivatives and their uses

This article explains the meaning of derivative, hedge, forward contract-forward rate agreement (FRA)- futures contract – call options – put options – SWAP transactions – swap margin – arbitrage,  Over-the-counter (OTC)- Difference between forward contract and futures contract, What is counterparty risk, Difference between futures and options, Portfolio & Portfolio management.

What is a derivative?

In a layman’s language, derivative means profit or loss derived from something. The most common derivative instruments used in financial markets are the forward contract, options, forward rate agreement, futures contract, interest rate swaps etc.  The characteristic and value of these derivative instruments are derived from underlying assets like currencies, Interest rates, stocks indices, precious metals, bonds, and stocks etc.

The derivatives are used to hedge the various types of risks. The investors, who are disinclined to take risk purchase or sell derivatives which may occur due to fluctuations in market price at a future date. The speculators who are ready to take the risk go for buying and selling such derivatives with the hope of making more profit from such deal. In the other words, the derivative transactions actually used to hedge the risks of investors who are risk averse to those who are ready to take the risk to earn more profit.

The meaning of hedge:

Hedging of an asset is an act of risk reduction in order to reduce the potential losses due to adverse price movements in an asset. Normally, an entity hedges the market risk to his assets by using derivatives (call options, put options,  or futures contracts) to offset the future changes in a related security. A hedge may also help the entity to lock in desired profit.

The meaning of forward contract:

A forward contract means an agreement between two parties to buy or to sell an asset at a specified price on a future date. For example, in foreign exchange market ‘forward contract’ means an exchange agreement between two parties to deliver one currency in exchange for another currency at a forward or future date.

Meaning forward rate agreement (FRA)

A forward rate agreement (FRA) is an over-the-counter contract privately negotiated between two parties that decide the rate of interest, or the currency exchange rate, to be paid or received on an obligation at a forward or future date.

Meaning of Over-the-counter (OTC)

Derivatives are traded in exchange house or over the Counter (OTC). The Over-the-counter (OTC) derivatives are the private agreements between two parties, without going through an exchange or other intermediaries. The popular products like swaps, forward rate agreements, are the examples of OTC.

Meaning of futures contract

Futures are exchange traded contracts made between two parties to buy or sell a specified commodity, foreign currency or a financial instrument at a pre-determined price on a fixed future date. In features, the price of a commodity or a financial instrument (ex: shares of a company) already fixed by the buyer and seller on the date of the contract, with a condition that it should be delivered to the buyer on a future date (delivery date). The future contracts are traded in the futures exchange.

Unlike options, in the future contract, the buyer and seller must complete the deal as agreed in the future contract.

The difference between forward contract and futures contract:

Both forward contract and future contract are similar in nature. The main difference between the two is that the forward contracts are privately negotiated whereas the futures contracts are standardized and traded on an exchange. Futures are traded on organized exchanges whereas the Forwards are bilateral contract traded over the counter. The contract of futures can be reversed with any member of the Exchange, but in the forward contract, the contract can be squared off only with the same counterparty with whom the contract was originally entered into.

Counterparty risk:

Counterparty risk means default risk. The counterparty risk arises when one of the parties to the contract fails to live up to the terms and conditions of the contract. Therefore, it is important for both the parties in bilateral contracts, like a forward contract or swap contract, to evaluate the opposite party’s ability to discharge the contractual obligations.

The Meaning of options: option is an agreement between two parties offering to buy or sell a security (a stock, bond, commodity or other instruments) from or to the other party at a specified price within a specific time period. In option contracts, there is no obligation on the part of buyer or seller to buy or sell the asset at ‘exercise price’; hence the parties to the deal call it an “option.”

Call option: Call option is the option of the buyer to buy an asset at a specified price and time.

Put option: Put option is the right of a seller to sell an asset at a specified price and time.

Obligations of buyer or seller under option contract:

In options, the parties to the contract will make the transaction under option, only if the deal is profitable to them.

In case., (when the transaction under option does not take place) only the option money or premium, (the difference between the price fixed under option contract and the price of the security on delivery date), is only payable to the  option holder. The agents of trade and industry normally hedge, the assets by way of options, against the risk of wide fluctuations in prices. The options also allow dealers and speculators to gamble for large profits with limited liability. The maximum option period allowed is one calendar month. If the delivery date or the last date of the option happens to be a holiday, the delivery has to be effected on the preceding working day.

The difference between futures and options:

In future contract, the buyer and seller must complete the deal as agreed in the future contract. In option contracts, there is no obligation on the part of buyer or seller to buy or sell the asset as per contract. However, the amount of loss or profit due to fluctuations of prices of the asset on delivery dates, to be passed on to the beneficiary holder of the option.

The meaning of SWAP transactions:
A ‘Swap’ is an act of exchanging one thing for another. In derivative market, currencies swap, interest rates swap or commodities swaps are most common.

Currency Swap: When buying and selling of a foreign currency with different delivery dates simultaneously take place, it is called SWAP transaction. Currency swaps are used to hedge interest rate risk and exchange rate risk of a currency.
Commodity swap: In commodity swap, underlying commodity is traded for a fixed price at a different delivery date over a specified period.

Interest rate swap: In Interest Rate market (IRS), investors take a view on fall or rise in interest rates and enter into a transaction with another party having the opposite view. Any fluctuation in the interest rate on post contract will be a profit or loss to the holder depending on their position in the IRS. IRS is primarily a hedging tool for portfolio investors.

Initially, in the interest rate swap market, banks and bond houses used to cut deals covering the risk from rate fluctuations. In May 2016, Reserve Bank has allowed institutional entity regulated by RBI, the Securities and Exchange Board of India, the Insurance Regulatory and Development Authority of India, the Pension Fund Regulatory and Development Authority and the National Housing Bank to trade in interest rate swaps on electronic trading platforms. With the above permit, more institutional investors like Insurance companies will now participate in Interest Rate Swap.

Swap margin: Swap margin is the discount or premium between the spot rate and the forward rate for a currency/commodity.

Portfolio & Portfolio management:

A portfolio denotes the collection of investment products such as stocks, shares, mutual funds, bonds, cash etc.

Portfolio management indicates managing the money of an investor depending upon his income and time frame for investments. The portfolio manager would council the investor client and understands his financial requirements and provides his expert guidance to the investor about the various investment products associated risks on such investments.  He further helps the investor in selecting the right type of investment plans which would guarantee minimum risk and maximum return. The above act of portfolio manager selecting the right type of investments to his client is called portfolio management.

Meaning of arbitrage: When an entity goes for simultaneous purchase and sale of a financial instrument on different markets or in different forms by exploiting the price difference in different markets, it is called the Arbitrage. The trader involved in arbitrage makes the profit from the difference of prices at different markets.

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