Derivative Categories

A Derivative is a financial product that is derived out of the value of an underlying asset. Derivatives are very popular and are widely used financial instruments.

Derivative products can be classified into the following main types:

1. Forwards
2. Futures
3. Options
4. Swaps
5. Warrants
6. Leaps &
7. Baskets

Out of these Futures & Options are actively traded on organized stock exchanges whereas Forwards are traded in OTC Exchanges.

Forwards Contract:

A forward contract is the simplest of the Derivative products. It is a mutual agreement between two parties, in which the buyer agrees to buy a quantity of an asset at a specific price from the seller at a future date. The Price of the contract does not change before delivery. These type of contracts are binding, which means both the buyer and seller must stay committed to the contract. This means they are bound to deliver or take delivery of the product on which the forward contract was agreed upon. Forwards contracts are very useful in hedging.

Important Characteristics of Forwards Contracts:

1. They are Over the counter (OTC) contracts
2. Both the buyer and seller are bound by the contractual terms
3. The Price remains fixed


Limitations of Forwards contracts:

1. Lack of centralized trading. Any two individuals can enter into a forwards contract
2. Lack of Liquidity
3. Counterparty risk - The case wherein either the buyer or seller does not honour his end of the contract.

Futures Contract:

A futures contract is an agreement to buy or sell an asset at a certain time in the future at a specific price. The Contractual terms of the futures contracts are very clear. The Futures market was designed to solve the shortcomings in the forwards contracts. Unlike forwards, futures are traded in organized exchanges. They also use a clearing house that provides the necessary protection to both the buyer and the seller. The price of the futures contract can change prior to delivery. Hence, both participants must settle daily price changes as per the contract values.

An Example of a futures contract would be an agreement to 100 tonnes of Steel at Rs. 10000/- per tonne at some date say in December 2008. If no interim payments are made and if the price of Steel moves violently, a considerable credit risk could build up. To avoid this a margin system is used by the exchanges. As per the margin system, both parties must deposit a small sum with the exchange. This amount will be a small percentage of the total contract. This amount is called the initial margin. As the steel value changes, the contract value also changes. If the contract value changes, the margin must be topped up by an amount corresponding to the change in price of steel. The margin money is the property of the person who deposits it and would be returned to them if the contract gets cancelled/completed.

Characteristics of Futures contract:

1. They are traded in organized exchanges
2. Credit risk is eliminated with the margin system. Both parties deposit a portion of the contract with the clearing house.
3. Both the buyer and seller are bound by the contract terms and are expected to honour their end of the contract.

Options Contract:

An options contract is nothing but the right to buy or sell something at a specified price within a period of time. The feature of the options contract for a buyer is that, the buyer has the right to buy, but he may choose to buy or may even choose to cancel the contract. Hence the buyers maximum loss is only the initial amount that was paid to gain the rights. Unlike buyers, the options contracts for sellers is an obligation. If a seller enters into an agreement, he has to deliver the asset on the specified date and the price agreed upon. Thus the loss for a seller could be much worse.

The right to buy is called a "CALL" option while the right to sell is called a "PUT" option. Please note that an option is only a right to do something. It is not an obligation to carry out the action. For a buyer it is only a right and not an obligation, but for a seller it is an obligation.

For Example, you want to buy Gold. You form an options contract with a Gold merchant to buy 1000 grams of Gold at the rate of say Rs. 1000/- per gram of gold on December 1st 2008. The total value of the contract would sum up to 10,00,000/- (10 lacs) As part of getting into the contract you make an initial payment of say 2% of the contract value to the merchant. You make a payment of Rs. 20 thousand (Rs. 20,000/-) and the contract gets formed. Now you are the buyer and the merchant is the seller.

Now there could two possible scenarios:

1. Assuming on 1st December the price of gold is Rs. 1050/- per gram, then to buy thousand grams of gold you would need Rs. 10,50,000/- rupees which is Rs. 50,000/- more than your options contract. Hence if you exercise your right to buy, you stand to make a profit of Rs. 50,000/- At the same time, the seller has an obligation since he has agreed on the contract and he has to sell the gold to you at a loss of Rs. 50,000/- when compared to the market rate.

2. Assuming on 1st December the price of gold is Rs. 950/- per gram, then to buy thousand grams of gold you would need Rs. 9,50,000/- which is Rs. 50,000/- less than your options contract. Hence if you exercise your right to buy, you stand to lose Rs. 50,000/- You can buy the same quantity of gold in the market at a lesser price. Hence you can choose to let your contract expire and limit your losses to only Rs. 20,000/- The Seller on the other hand does not make any transaction but still stands to keep the Rs. 20,000/- you paid him to form the contract.

This 1000 rupees per gram that you agreed upon with the merchant is called the "Strike" Price.
The initial deposit of Rs. 20,000/- you paid him is called the "Option premium".

Partcipants in an Options market:

1. Buyers of Calls
2. Sellers of Calls
3. Buyers of Puts
4. Sellers of Puts

People who buy options are called "Holders" and those who sell options are called "Writers"

Call Holders and Put Holders (The Buyers) are not obligated to buy or sell. They have the right to do so if they wish. Similarly Call writers and Put Writers (The Sellers) are obliged to buy or sell. This means that they need to buy or sell if the Call holder decides to exercise his right to buy.

Characteristics of Options Contracts:

1. Unlike other derivative products that are price fixing contracts, options are price insurance type of contracts
2. Options have been basically OTC products. But of late, due to its popularity, exchange traded options are also being widely used.
3. The options are very favourable to the Holders or the Buyers.

Widely used terms in Options contracts:

In-the-Money - An ITM option is one that would lead to a positive cash flow to the holder if it were exercised immediately. For e.g., If you have an options contract to buy shares of XYZ limited at Rs. 100/- per share and it is currently trading at Rs. 120/- per share then your options contract is said to be In the Money.

At-the-Money - An ATM option is when the prevailing price of the asset and your option price are more or less same.

Out-of-the-Money - An OTM option is when the prevailing price of the asset is lesser than the option price.

An Example call Option with respect to the Share Market:

You buy 10 call options for the company XYZ pvt ltd, at the strike price of Rs. 325/- at a premium of Rs. 10 per option. The option is valid till 30th Oct 2008.

Two things can happen here:

1. You can make a profit:

Say on the date of expiry the share of XYZ pvt ltd is trading at Rs. 380/- per share, then you can opt to exercise your call option. Hence you would be getting 10 shares of XYZ ltd at Rs. 325/- which you can sell at Rs. 380/-

Your Input cost per share = 325
Premium per share = 10
Market value during Selling = 380

Your Profit per share = 380 - (325+10) = Rs. 45 /-

Net Profit = Rs. 450/-

Here Rs. 325 is the Strike price and Rs. 380 is the spot price.

2. You can incur a Loss:


Say on the date of expiry the shares of XYZ pvt ltd is trading at Rs. 275/- per share, then you can opt to let the contract expire. Since you are the buyer or the call holder you can opt to either buy or let the contract expire. Since the share is available in the market at a lesser price than the strike price, it is not wise to exercise the option. Hence you ignore it.

Your input cost = Rs. 10/- (The premium you paid per option)

Loss incurred = Rs. 100/- (Because you do not make any other payment apart from the premium)

Loss you would have incurred if you had exercised the option:

Cost per share = 325
Premium per share = 10

Market value during selling = 280

Your loss per share = (325+10) - 280 = Rs. 55/-

Net Loss: Rs. 550/-

Incurring a loss of Rs. 100/- is better than incurring a loss of Rs. 550/- hence your decision of letting the contract expire was a wise decision.


An Example Put Option with respect to the Share Market:

You buy 10 put options for the company XYZ pvt ltd, at the strike price of Rs. 300 per share at a premium of Rs. 10 per option. The option is valid till 30th Oct 2008.

Two things can happen here:

1. You can make a profit:

Say on the date of expiry, the shares of XYZ is trading at Rs. 265/- per share, then you can opt to exercise your contract. You can buy 10 shares of XYZ from the market and then sell your shares to the option writer since he has an obligation to buy if you intend to sell.

Your premium = 10
Your input cost per share = 265

Price at which the Put option is exercise = 300

Profit per share = 300 - (265 + 10) = 25

Net Profit = Rs. 250/-

2. You can make a Loss:

Say on the date of expiry, the shares of XYZ is trading at Rs. 325/- per share, then you can opt to let the contract expire. Since the share is trading at a price more than the option price, you can choose to let the contract expire.

Your premium = 10

Loss incurred = Rs. 100/- (The premium paid)

Even in this case, this loss would be compensated by the fact that you can sell off the shares that you have in the market at a higher price than the option strike price.


Swaps:

A Swap is an agreement between two parties to exchange future cash flows according to a predefined formula. These streams of cash flow are called the "Legs" of the swap. Usually, when the swap contract is formed at least one of these series of cash flows are determined by a random or uncertain value like interest rate or equity price etc.

Most swap contracts are traded OTC which are tailor made for the counterparties. Some are also traded in organized exchanges. The five generic types of swaps are:

1. Interest rate swaps
2. Currency swaps
3. Equity swaps &
4. Commodity swaps

Interest Rate Swaps:

In Interest rate swaps, each party agrees to pay either a fixed or a floating rate in a particular currency to the other party. The fixed or floating rate is multiplied with the Notional Principal Amount (NPA) say Rs. 1 lac. This notional amount is not exchanged between the parties involved in the Swap. This NPA is used only to calculate the interest flow between the two parties.

The most common interest rate swap is where one party 'A' pays a fixed rate to the other party 'B' while receiving a floating rate which is pegged to a reference rate like LIBOR.

LIBOR - London Inter Bank Offer Rate

For e.g., a Swap arrangement between two people could be like, 'A' pays a fixed rate of 3% to 'B' on a principal of Rs. 1 lac every month and 'B' in turn would pay 'A' at the rate of LIBOR + 0.5%. The cash flow that 'B' can expect from 'A' is fixed whereas the value that 'A' would receive would vary based upon the LIBOR. If the LIBOR that month is 2% then 'A' would receive an interest of 2.5% that month. The fixed rate of 3% is termed as the 'Swap Rate'

Note: The LIBOR is taken as just an example. The swaps may be pegged with any reference rate that is common to both parties.

At the point of Initiation of the Swaps the swap is priced in such a way that the "Net Present Value" is '0'. If one party wants to pay 50 bps (Basis points or 0.5%) above the Swap rate, then the other party may have to pay the same 50 bps above LIBOR

Net Present Value - NPV is defined as the total present value of a series of cash flows. The term NPV is used widely in the financial terms and it is used by people to decide on whether to invest in an instrument or not. A NPV > 0 indicates a good investment opportunity and a NPV < style="font-style: italic;font-size:130%;" >Currency Swaps:

The Currency Swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. Just like interest rate swaps, the currency swaps also are motivated by comparative advantage. Unlike Interest rate swaps, currency swaps include payment of Principal amount as well. For e.g.,

- Party 'A' Receives a 8% rate of interest on Rs. 1 crore every 6 months
- Party 'B' Receives a 11% interst on USD $25,00,000/-
- Cash flow is exchanged every 6 months for 5 years
- Principal amount is exchanged at both the beginning and end of the contract.

Equity Swaps:

An Equity Swap is a special type of swap where the underlying asset is a stock or a group of stocks or even a stock market index. The key differentiator in equity swaps is the fact that the floating leg of the payment is dependent on the performance of the underlying stock. One party would receive fixed amounts regularly while the other would receive a payment depending on the performance of the Stock upon which the Equity swap is created.

Commodity Swaps:

A commodity swap is similar to Equity swaps wherein the floating payment would depend on the price of the underlying commodity. for e.g., A commodity swap may be created on Gold. Party 'A' would receive fixed payments from 'B' every month, whereas the payment 'B' received would vary every month based on the price movement of Gold in the market. A vast majority of commodity swaps use "OIL" as the underlying commodity.

Warrants:


Options generally have a life of upto One year. Most options that are traded on exchanges have a life of 9 months. Longer dated options are called Warrants and are generally traded OTC. A Warrant is a certificate issued to a buyer who is entitled to buy a specific amount of securities at a specific price (Usually greater than the current market price) for an extended period which may range from a few years to more...

In the case where the price of the security is more than the Warrant's exercise price, the holder of the warrant can exercise his right to buy it and sell it in the open market and make a profit. If the warrant does not get used, it would just expire or remain unused until the life of the Warrant.

LEAPS:

Leaps stand for - Long Term Equity Anticipation Securities. These are options that have a maturity of upto 3 years. Usually the Equity Leaps would expire in January. For e.g., if you want to buy an equity leap this month Oct 2008, it may expire in Jan 2009, 2010 or 2011. Here the contracts that expire in 2010 and 2011 may be considered as Leaps due to the maturity duration. The further the expiration date, the costlier the Leap.

Baskets:

A Basket is an economic term for a group of several securities created for the purpose of simultaneous buying/selling. For e.g., Index funds can be considered as a basket of all securities that are listed in a particular Exchange weighted appropriately.