Finance: Introduction to Derivatives

Before coming to derivatives, let us talk about a simple trade between a farmer and a miller.

A farmer and a miller makes an agreement to trade wheat at a particular price in future. This would guard both farmer and miller against uncertainty in price. The farmer will loose any additional gains he could have achieved if there is a price rise. If the price falls, the miller will have to pay additional money for purchasing wheat thereby making a loss. This agreement can be termed Forwards. Forwards are one type of derivative trade and if you understood this trade example, you got the base of derivatives.

Derivatives are the financial instruments whose returns are derived from an underlying assets. In case of the example we discussed, the underlying asset is wheat and futures price and agreement would be decided based on the price of underlying asset, i.e. wheat. The underlying assets can be based on real physical assets (like agricultural commodities,metals etc.) or financial assets like stocks, currencies etc.

Hedging: Derivatives are used by companies and individuals to transfer any undesired price risk or unpredictability of price to another party. The other party takes the unpredictability of price risk and may achieve gain or loss based on the price of underlying commodity at the time of trade execution.
In case of the example we discussed, the farmer has hedged or removed any price risk he may have to face at the time of harvest.

Speculation and Arbitrage: The typical example of a speculator is a person who trades in stock market with the motto of making profits and is not looking forward for a physical trade. The person who buys a derivative to acquire price risk and therefore look to make financial gains out of it based on some speculations and forecast is called a speculator.

Derivatives can be classified as exchange traded and over the counter (OTC) traded.

Over The Counter (OTC) Traded derivatives: 

These are contracts that are traded directly between two parties without going to a regulated exchange. There is counterparty risk associated with an OTC trade.

Exchange Traded Derivatives: 

These are contracts that are traded over a regulated exchange. Each trade happens with an exchange and not directly with a counterparty. Since, exchange is the counterparty for trades happening over the exchange there is no counterparty risk involved here.

Types of derivative contracts:

1. Options: Options precisely means that the holder has an option to whether or not execute the trade contract. Option gives the option buyer right and not obligation to whether or not execute the trade contract.
The option buyer pays the seller an amount of money called as premium. An option to buy something is called as call and an option to sell something is known as put.
The maximum loss that an option buyer can incur is the premium itself. This is because the option buyer will execute the underlying trade only if he gets some profit. So, the option buyer can have profit of any margin and maximum loss equivalent to premium. Inversely, the maximum profit that an option seller can get would be option premium and the loss can be of any magnitude. Options can be OTC or exchange traded.
Different type of options are European option, American option, Average price option.
American option can be executed at any time before expiry, European option can be exercised only on contracted expiry date. In case of Average price option, option is exercised with average price over the settlement period.
In India, we use European options.

2. Forward Contracts: Forwards are tailor made contract between two parties that is to be executed at a future date at an agreed price. This is strictly an OTC traded derivative. The need for such a contract lies in the customization requirement of the agreement between two parties that is agreed to be done in future. If the parties are intending to do a physical transaction of traded commodity, then there needs to be  an agreement on quality of the commodity, penalty for delay etc.

3. Future Contracts: A future contract is also a contract between two parties that is to be executed at a future date at an agreed price like Forwards. But Forwards is strictly traded over the exchange and is targeted for speculators. Future contracts are traded on organized exchanges called futures markets.

4. Swap contracts: Swap is a contract in which two parties agree to exchange cash flows. This can be based on two fixed prices or floating prices. An example of swap trade is agreement between airline and fuel company. Fuel company agrees to provide a fixed price for the airline fuel at a mentioned date and the airline company is ready to give the average price on exchange index in return.

5. Exotics: There are hybrid derivatives which are combinations of one or more of the above derivatives.