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Derivative

By Irina Balalaeva, International Fixed Income Group of Cbonds
Updated June 26, 2024

What is a Derivative?

Derivatives are financial contracts that derive their value from an underlying asset, group of assets, or benchmark. These contracts are established between two or more parties and can be traded either on an exchange or over-the-counter (OTC). The value of derivatives is closely tied to fluctuations in the underlying asset, and they serve as a means for market participants to access various markets.

These financial instruments come with their own set of risks and are utilized for a variety of purposes. Derivatives can be employed for hedging, where they act as a tool to mitigate risk. On the other hand, they can also be used for speculation, where individuals or entities assume risk with the expectation of corresponding rewards. Essentially, derivatives play a crucial role in transferring risk, and the potential rewards associated with it, from those who are risk-averse to those who are risk-seeking.

Derivative

Derivatives Explained

Derivatives represent a sophisticated category of financial securities established between two or more parties. Traders utilize derivatives as a means to access specific markets and engage in the trading of diverse assets. Often considered a form of advanced investing, derivatives find their foundation in various underlying assets, with stocks, bonds, commodities, currencies, interest rates, and market indexes being among the most common.

The values of derivative contracts are intricately linked to fluctuations in the prices of the underlying assets. These financial instruments serve multiple purposes, allowing traders to hedge positions, speculate on the directional movement of underlying assets, or leverage holdings. Derivatives are typically traded on exchanges or over-the-counter (OTC) and are acquired through brokerages.

In the realm of over-the-counter (OTC) trading, derivatives may carry an elevated risk of counterparty default. Counterparty risk involves the possibility that one of the transaction parties might fail to meet its obligations. OTC-traded derivatives, conducted between private parties without regulation, may present this risk.

Advantages and Disadvantages of Derivatives

Advantages

  1. Lock in Prices. Derivatives provide the ability to secure predetermined rates for future transactions, offering a valuable means of price protection in volatile markets.

  2. Hedge Against Risk. These financial instruments serve as effective tools for managing risk, allowing individuals and businesses to safeguard themselves against adverse market movements.

  3. Can Be Leveraged. Derivatives offer the opportunity to control larger positions with a smaller investment through leverage, potentially amplifying returns, albeit with increased risk.

  4. Diversify Portfolio. Incorporating derivatives in investment portfolios allows for diversification, offering exposure to a wide range of assets and markets to spread risk.

Disadvantages

  1. Hard to Value. The complex nature of derivatives, combined with changing market conditions, makes accurate valuation challenging.

  2. Subject to Counterparty Default (if OTC). Over-the-counter (OTC) derivatives, traded without regulation, carry the risk of counterparty default, posing potential financial losses if one party fails to meet obligations.

  3. Complex to Understand. Derivatives’ intricate nature requires a certain level of financial sophistication, presenting a barrier for some investors and businesses who may find them challenging to fully comprehend.

Types of Derivatives

  • Options are financial contracts that grant the buyer the right (but not the obligation) to buy or sell an underlying asset at a predetermined price within a specific timeframe. American options allow exercise before expiration, while European options can only be exercised on the expiration date.

  • Futures contracts are standardized agreements allowing the contract holder to buy or sell an underlying asset at a predetermined price on a specified date. Parties involved have both the right and obligation to fulfill the contract. Traded on the exchange market, futures contracts are highly liquid, intermediated, and regulated.

  • Forwards. Similar to futures contracts, forwards involve the holder having both the right and obligation to fulfill the contract. Unlike futures, forwards are over-the-counter products, lacking regulation and specific trading rules. These contracts are unstandardized and customizable to suit the needs of the parties involved.

  • Swaps are derivative contracts where two parties exchange financial obligations. Common types include interest rate swaps. Unlike options, futures, and forwards, swaps are not traded on the exchange market but over the counter. They are highly customizable to meet the specific needs and requirements of the parties involved. Various types of swaps, such as credit default swaps, inflation swaps, and total return swaps, have emerged as the market’s demands have evolved.

Valuation of Derivatives

Market Pricing

The market price for exchange-traded derivatives is typically transparent, being published in real time by the exchange. However, challenges may arise with over-the-counter (OTC) or floor-traded contracts due to manual handling and the absence of automatic price broadcasting.

Arbitrage-Free Pricing

Arbitrage-free pricing is a complex aspect, particularly for options and more intricate derivatives. For futures/forwards, determining the arbitrage-free price involves considering the price of the underlying asset along with the cost of carry (income received less interest costs). Options and complex derivatives necessitate sophisticated pricing models that understand the stochastic process of the underlying asset’s price. The Black–Scholes formula is a key equation for options, assuming that cash flows from a European stock option can be replicated through continuous buying and selling.

The binomial options model offers a simplified version of the valuation technique. Over-the-counter (OTC) derivatives pose challenges in pricing due to the absence of a publicly traded market. Without a market price for validation, OTC derivatives are often priced by independent agents designated by both counterparties involved in the deal. Most OTC derivatives pricing relies heavily on input-dependent models, making the upfront designation of independent agents crucial in the pricing process.

How Derivatives are Traded?

Over-the-Counter (OTC) Trading

  • Bilateral Transactions. The majority of derivatives are traded over-the-counter in bilateral transactions between two counterparties. These counterparties often include banks, asset managers, corporations, and governments.

  • Agreement Documents. Professional traders engaged in OTC trading have signed agreements in place with one another to ensure consensus on standard terms and conditions. This helps establish a clear framework for their derivative transactions.

Exchange-Traded Trading

  • Specialized Exchanges. Some derivative contracts, such as options and futures, are traded on specialized exchanges. This introduces a more standardized and regulated approach to derivative trading.

  • Prominent Exchanges. Major derivative exchanges globally include the CME Group (Chicago Mercantile Exchange and Chicago Board of Trade), the National Stock Exchange of India, and Eurex.

Participants of Derivatives Market

Hedgers

  • Definition. Hedgers employ financial market instruments, including derivatives, to mitigate existing risk or future exposure.

  • Example. A farmer may sell cattle futures to reduce price uncertainty when preparing to sell their herd.

  • Significance. Derivatives, being linked to the performance of underlying assets, are popular hedging instruments.

Speculators

  • Definition. Speculators engage in market activities by taking educated gambles on asset price movements for short-term gains.

  • Example. A speculator may use options to gain exposure to an asset without owning it directly, making it a cost-effective strategy.

  • Significance. Derivatives, especially options, offer an inexpensive and liquid way for speculators to access markets and manage risks.

Arbitrageurs

  • Definition. Arbitrageurs seize opportunities arising from mispricings in assets to secure risk-free profits.

  • Example. If gold futures trade higher than the spot price, an arbitrageur may sell futures, buy gold at spot, and lock in a riskless profit.

  • Significance. Arbitrageurs play a crucial role in maintaining relationships between asset prices in the derivatives market.

Margin Traders

  • Definition. Margin traders leverage collateral deposited with brokers or exchanges to amplify their investment power.

  • Example. In foreign exchange or cryptocurrency trading, where significant capital is needed, margin traders use derivatives to avoid tying up large amounts of trading capital.

  • Significance. Derivatives, particularly in markets like foreign exchange and cryptocurrencies, enable margin traders to magnify potential returns while managing risk.

Examples

Example 1 – Forwards

  • Scenario. ABC Inc. manufactures cornflakes and needs to purchase corn at $10 per quintal from Bruce Corns.

  • Concerns. The possibility of heavy rainfall affecting corn prices and profit margins for ABC.

  • Agreement. Parties agree to fix the corn price at $10 per quintal for six months.

  • Outcome. If corn prices rise due to rainfall, ABC pays $10, protecting its margins. If prices fall, Bruce Corns profits, and ABC may face higher costs.

Example 2 – Futures

  • Scenario. Corn futures are traded in the market; ABC Inc buys 10,000 contracts at $40 per contract due to a forecast of heavy rainfall.

  • Outcome. If rainfall occurs, and corn futures rise to $60 per contract, ABC gains $20,000. If the prediction is wrong, and market demand increases, prices drop to $20, and ABC may purchase more contracts to offset losses.

  • Comparison to Forwards. Futures are exchange-traded instruments, providing standardized contracts overseen by regulators.

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