What is a derivative?
– A derivative is a financial contract whose value depends on the price or behavior of another item called the underlying asset. Common underlyings include stocks, bonds, commodities, currencies, interest rates, and indexes. Parties enter derivative contracts to transfer risk, to bet on future price moves, or to gain a larger exposure to an asset with a smaller upfront cost.
Key jargon (defined on first use)
– Underlying asset: the instrument (e.g., a stock or currency) whose value determines the derivative’s price.
– Hedge: an action intended to reduce or offset risk from an existing exposure.
– Speculate: taking a position to profit from expected price changes, accepting corresponding risk.
– Leverage: using a small amount of capital to obtain a larger exposure to an asset; amplifies gains and losses.
– Counterparty risk: the chance that the other party to a privately negotiated contract will fail to meet its obligations.
– OTC (over the counter): a contract negotiated privately between parties rather than traded on an exchange.
– Exchange-traded: contracts standardized and traded through an organized exchange.
– Expiration: the date when a derivative must be settled or exercised.
– Margin: collateral required to open or maintain a leveraged derivative position.
How derivatives work (simple overview)
1. Two or more parties agree on contract terms that reference one or more underlying assets or a benchmark.
2. The derivative’s value moves as the underlying’s price or indicator changes. Parties settle differences either by delivering the underlying asset or by paying/receiving cash.
3. Contracts may be standardized and exchange-traded (lower counterparty risk, greater regulation) or customizable and traded OTC (greater flexibility, higher counterparty risk).
4. Uses include: hedging an existing exposure, speculating on future moves without owning the underlying, and obtaining leveraged exposure.
Main contract types (concise definitions)
– Futures: Standardized contracts, traded on exchanges, obligating the parties to buy or sell the underlying at a preset price on a future date. Many futures are cash-settled (paid in cash rather than delivered physically).
– Forwards: Customized agreements between two parties to buy or sell an asset at a specified future date and price. Forwards trade OTC and carry counterparty risk.
– Swaps: OTC agreements to exchange cash flows (for example, fixed vs. floating interest payments or different currencies) over time.
– Options: Contracts that grant the holder the right, but not the obligation, to buy (call) or sell (put) the underlying at a specified price before or at expiration.
Two broad product classes
– Lock products: both parties are bound to the contract terms from the start (example: futures, forwards, swaps).
– Option products: give one party a choice to act or not (example: stock options).
Advantages and common uses
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– Advantages and common uses –
– Hedging (risk management): Firms and investors use derivatives to reduce exposure to price movements in an underlying asset. Example: an airline buys futures or calls on jet fuel or uses swaps to lock future fuel costs, reducing profit volatility.
– Speculation: Traders take directional positions to profit from expected price moves without owning the underlying. Speculative positions can be low-capital (because of leverage) and high-risk.
– Arbitrage: Traders exploit price differences between related instruments or markets (for example, spot vs. forward) to lock in riskless profit until prices converge.
– Price discovery: Derivative markets aggregate expectations about future prices and can provide information useful to spot markets.
– Access and financing: Derivatives can provide exposure to assets that are difficult or expensive to hold directly (foreign interest rates, commodities, credit exposures) or can be structured to synthetically replicate positions.
– Balance-sheet and regulatory management: Institutions use derivatives (e.g., interest-rate swaps) to alter the risk profile of assets and liabilities for accounting, capital, or funding purposes.
– Flexibility and customization: OTC derivatives (forwards, swaps) allow tailor-made contract terms (amounts, dates, currencies), while exchange-traded contracts standardize and centralize clearing.
– Key risks
– Leverage risk: Derivatives often require a small initial cash outlay (margin) relative to notional exposure. Small underlying moves can cause large gains or losses and margin calls.
– Counterparty risk: OTC contracts expose users to the risk that the other party defaults. Central clearing (via a central counterparty, CCP) reduces but does not eliminate this risk.
– Liquidity risk: Some contracts may be difficult to close or hedge quickly without moving the market.
– Model and valuation risk: Pricing can rely on models (e.g., Black–Scholes); incorrect inputs (volatility, rates) or model
misspecification — will produce wrong valuations and hedges that fail when market conditions differ from model assumptions.
Other operational and legal risks
– Operational risk: Errors in trade capture, settlement, collateral management, or IT systems can create losses or failed trades. Manual processes increase this risk.
– Legal and documentation risk: Poorly drafted contracts or unclear master agreements (e.g., ISDA, the International Swaps and Derivatives Association agreement) can create disputes about terms, netting, or closeout.
– Settlement and delivery risk: Physical delivery or cash-settlement terms can create timing mismatches. A counterparty may default at settlement (settlement risk).
– Basis risk: When a hedge uses a derivative whose underlying is not perfectly correlated with the exposure being hedged (different grade, tenor, or index), residual risk remains.
– Regulatory and compliance risk: Changes in regulation (margin rules, clearing mandates, position limits) can alter economics and operational requirements.
How derivatives are priced and valued (practical notes)
– Notional vs. market value: Notional amount is the contractual reference size (e.g., 1,000 barrels). Market value is the current economic value of the contract (what you could receive or pay to terminate it).
– Simple payoff formulas (at expiry):
– Long call option payoff = max(S – K, 0) where S = spot price at expiry, K = strike. Net profit = max(S – K, 0) – premium paid.
– Long put option payoff = max(K – S, 0). Net profit = max(K – S, 0) – premium.
– Futures/P forwards payoff (long) = S_T – F_0 (for a contract agreed at forward price F_0).
– Common model: Black–Scholes–Merton (BSM) provides a closed-form price for European calls and puts under assumptions (lognormal underlying, constant volatility, no dividends or continuous dividend yield, constant interest rates, frictionless markets). Key inputs: current price S, strike K, time to expiry T, volatility σ, risk-free rate r, and dividends q.
Worked numeric examples
1) Option leverage example (call):
– Underlying stock price today S0 = $50.
– Call strike K = $55, premium = $2, expiry in 3 months.
– If at expiry S = $65, payoff = max(65 – 55, 0) = $10. Net profit = $10 – $2 = $8.
– Return on premium = $8 / $2 = 400%. The notional exposure at expiry is $10 intrinsic value × contract size (if 100 shares per option, intrinsic = $1,000). This shows high percentage returns relative to premium but note you could also lose 100% of premium if S ≤ $55.
2) Futures margin/leverage example:
– One futures contract = 100 units. Futures price = $1,000 → notional = $100,000.
– Initial margin = $5,000 (5% of notional). If the index falls 3% (–$3,000 per contract), the holder loses $3,000 and may face a margin call. Small percentage moves in the underlying can create large impacts on posted capital.
Key Greeks (risk sensitivities) — concise definitions
– Delta: change in option price per $1 change in underlying spot (directional exposure).
– Gamma: change in delta per $1 change in underlying (rate of delta change).
– Vega: sensitivity of option price to a 1 percentage-point change in implied volatility.
– Theta: time decay — change in option price per day as time to expiry shortens.
– Rho: sensitivity to interest rates.
Practical checklist for using derivatives
1. Define objective: hedging, yield enhancement, arbitrage, or speculation. Be specific (what exposure, over what horizon).
2. Choose instrument: futures/forwards, options, swaps, or combination. Consider liquidity and standardization.
3. Quantify exposures and notional amounts precisely.
4. Model pricing and sensitivity: compute delta, possible P&L scenarios, and stress tests (adverse moves, vol spikes).
5. Decide margin and collateral sources; plan for liquidity needs in margin calls.
6. Legal documentation: use appropriate master agreements and confirm netting and close-out rights.
7. Counterparty assessment: check creditworthiness, clearing status (CCP vs. bilateral).
8. Reconciliation and operational controls: trade confirmation, settlement, and margin calls.
9. Accounting and regulatory compliance: consult accounting rules and report as required.
10. Exit plan: how to unwind or roll positions; set stop-loss or risk limits.
Common uses with short examples
– Hedging: An exporter expecting EUR receipts in 90 days sells EUR forward to lock the USD price today.
Example: expected €1,000,000. Forward rate locked = $1.10/€. Locked USD receipts = $1,100,000.
– Speculation: A trader buys call options to bet on a stock rising with limited downside (maximum loss = premium).
– Arbitrage: Capturing price differences between markets (e.g., cash vs. futures) after accounting for carrying costs.
– Yield enhancement: Selling covered calls to earn premiums while holding the underlying.
Regulatory, clearing, and reporting environment (high level)
– Post-2008 reforms global regulators increased central clearing for standardized OTC derivatives to reduce bilateral counterparty risk (examples: Dodd–Frank Act in the U.S., EMIR in the EU).
– Mandatory trade reporting and margin requirements for uncleared OTC derivatives are now common in many jurisdictions.
– Accounting: Hedging relationships can be eligible for hedge accounting treatment (IFRS 9, U.S. GAAP ASC 815), which affects how gains/losses are recognized; documentation and effectiveness testing are required.
Final summary — what retail traders and students should remember
– Derivatives are contracts whose value derives from an underlying asset. They can be powerful tools for hedging and risk transfer but introduce leverage, counterparty, liquidity, and model risks.