- Published on
Opening the gates to the world of derivatives
- Authors
- Name
- Shashwat Kansal
Since their inception in the modern-day and age, derivatives are extensively traded around the world since their inception in the 1970s. They are values of financial instruments that change depending on the value of other financial distributions, hence the name "derivatives" which from maths you may recall is often used to find the change in the value of something. There are many different types of derivatives that you can have, such as forward contracts, options, futures, and swaps. Let's explore what some of these are and how they work:
Forward Contracts
Forward contracts are agreements that agree to sell an asset at an agreed price in a future date.
Let's say we want to trade some currencies, say the US Dollar (USD) vs the Euro (EUR). At the time of writing this, €1 = US$1.2181, and say you walk into the bureau de change with €10,000 and they give you this table of prices.
| Bid | Ask | |
|---|---|---|
| Spot | 1.2181 | 1.2179 |
| EURUSD 2 Week FWD | 1.2184 | 1.2182 |
| EURUSD 1 Month FWD | 1.2188 | 1.2186 |
| EURUSD 6 Month FWD | 1.2226 | 1.2223 |
| EURUSD 1 Year FWD | 1.2273 | 1.2271 |
With €10,000, you can decide to sell this to the exchange for US$12,179 if you choose to exchange immediately (using spot) as the exchange rate is 1.2179.
Now, what if you're part of a European company and you know you must give a payment of US$1 million after 6 months to a US-based company, say for exchange of some goods. You wouldn't want to worry about the exchange rate in the future due to volatility in the currency price, so you may want to use a forward contract to eliminate this risk. You can choose to buy the forward contract for 6 months at 1.2226, so the cost in that transaction in euros means you'll end up paying €817,929.
Now let's suppose you didn't buy the forward contract, and 6 months into the future what might happen is the currency exchange rate changes to say 1.2100, which will the then spot price. This means you'll end up paying around €826,446.28 - around €8,517.28 more!
This is one way how companies can protect themselves from currency risk. Sometimes, forward contracts may not be in your favour if the euro in this particular case gained strength over the dollar, i.e. say the exchange rate is 1.2500, then you'd end up losing almost 18,000 Euros, but the important point is that you know exactly what the price will be after those 6 months, removing any risk of the currency exchange rate working against you. Note that forward contracts are by no means limited to just currencies - it could be anything like commodities such as wheat and oil, to other financial instruments like index funds (don't worry about this for now).
Futures Contract
Futures contracts are agreements between two parties to buy or sell an asset at a certain time in the future for a certain price.
The fundamental difference between futures contracts and forward contracts is that futures are traded on exchanges (effectively like a middleman between the two parties in the contract), whereas forward contracts don't have to be.
Another fundamental aspect is that futures contracts don't have to be executed at a specified date, but typically a month is given and it can be executed anytime in the month. Of course, if say I was holding a short position in a contract for gold (i.e. I'm the one selling the gold), I can choose the day I want to deliver the gold to the other party within the month.
Options
Option contracts give the bearer the right (but not obligation!) to buy or sell an amount of some asset at an agreed strike price at or prior to the contract maturity.
Options are quite literally what they mean - options. You have an option to buy or sell something within an agreed time frame, but you don't have to if you don't want to. There are two fundamental kinds of options - call and put. A call option lets the bearer buy the asset and the put option lets the bearer sell the asset, and typically American options are executed in the market (which means you can execute the contract any time until the contract maturity), as opposed to European options in which you can execute the options contract only on the date of maturity.
Let's say you want to buy a house, and that house costs US$500,000. You could buy an American call option stating that you'll buy the house in the next 5 years for this price. It could be that the strike price is $10,000, which you'll have to pay upfront. Say in 4 years you see the value of the house is at $1,000,000, but since you have the options contract, you can buy it for just half, leaving you with $490,000 profit - what a deal right? However let's say that the house depreciated in the value to just $100,000. You don't have to execute your option, so you can just let it expire and go buy the house for $100,000 in the market. This way you're only making a loss of the strike price which was $10,000!
This time let's think the other way around, that you already own a house but you want to sell it later in the future. You buy an American put option with the same strike price of $10,000 with maturity in 5 years agreed to sell the house for $500,000. In 4 years the house's market value rises to $1,000,000, so you definitely don't want to sell the house using the put option since you can get more by selling it at the current fair market price - only a $10,000 loss from the strike price. But if the house value in 4 years drops to $100,000, then you can execute the put option leaving you with $390,000 profit compared to if you sold it at the current fair market value!
Essentially what you're hoping for is that if you buy a call option, you want the price of the item to rise so that you can buy it for cheaper (and perhaps immediately sell to immediate cash in on the difference in value). If you buy a put option, you want to see the value decrease, so that you can sell it for a greater value than is quoted in the market.
Long/Short vs. Put/Call
There are always two sides to the story to an options contract. In the examples we had just previously, we always assumed we were the ones buying the contract. As we wanted to buy or sell the house, we specifically bought long call options and long put options. An investor can also take the short position of a call or put option, essentially making them the writer of the contract. This time, they're not the ones paying the strike price, but they receive it, and since it's a zero-sum game, the person going short always gains or loses exactly the opposite of the person going long.
Let's go back to our previous examples and see what happens if you take a short position.
The person who wants to buy a house buys a call option for $500,000 with 5-year maturity at strike price agreed at $10,000 which they pay straight away. Now you are the one who has written this contract, and you straight away receive $10,000 - great. Now in 4 years say, the price of the house is now $1,000,000, and the house buyer executes the call option you wrote, making them in a gain of $490,000 while you're instead losing exactly $490,000 if you hadn't made the contract or they hadn't executed it. Conversely, if the house in 4 years is at $100,000 value, then the person taking a long position won't execute it, since they can just buy the house for cheaper without the contract. As a result, you're up with $10,000. Note that just because you took a short position doesn't mean you own the house (but does put significant risks on you, as is always the case by taking a short position).
Who uses derivatives?
Often, derivatives are used to hedge against a potential risk, like we saw when a company had to pay $1,000,000 in 6 months in the forward contract scenario.
Other cases include if you want to arbitrage, such as entering multiple transactions in different markets to get riskless profit. For example, if Tesla stock costs $610 in New York whereas in London it is going for 430GBP, where $1 = GBP0.71, so $610 = GBP 433.10, then you can gain on the difference in price. This is becoming increasingly harder today due to automated trades and software that can help trade high volume in short times correcting the market price very quickly as many arbitrageurs try to take advantage of it.
We also have the speculators that use derivatives where they're essentially betting that the market will move one way or the other and accordingly buy their forward contracts, futures, or options in such a way that it'll benefit them if their prediction in which way the market will go turns out to be right.
There's of course a lot more to derivatives than in this article, both in the types of derivatives available, such as swaps and securities. On top of that, there could be market restrictions such as the European Securities and Markets Authority which banned short selling for a day on March 18th, 2020!