Derivatives. Common Derivatives, How it Works, and Benefits

Derivatives are financial instruments that derive their value from the performance of an underlying asset, such as a stock or bond. Derivative contracts can be used to hedge against price movements in the underlying asset and/or to speculate on future changes in prices. The most common derivatives include futures, options and swaps.

Futures Contracts: Futures contracts allow buyers and sellers to agree upon the delivery date for a specified quantity of an underlying commodity at a predetermined price. A contract is said to expire worthless if it has not been settled by its expiration date. In this case, both parties receive no payment. If the buyer receives the goods before they have expired, he pays the seller the difference between the market price and the agreed- upon price. Conversely, if the seller delivers the goods prior to expiry, he collects the premium plus interest. This type of derivative transaction allows investors to profit when the price of the underlying instrument rises above the strike price set forth in the contract.

Options Contract: An option gives the holder the right but not the obligation to buy or sell a specific amount of an underlying security at a fixed price within a certain period of time. For example, a call option grants the owner the right to purchase 100 shares of XYZ Company at $50 per share until December 31st, 2010. At any point during the life of the option, the owner may exercise his rights under the option by paying the current market price for XYZ shares. However, the owner does not need to pay anything unless he actually exercises the option.

He will only lose money if the price drops below the option's strike price. On the other hand, a put option gives the holder the ability to sell 100 shares of XYZ company at $50 per share anytime up to January 1, 2011. Again, the owner must make good on his promise to deliver the securities if the price reaches the strike price. But unlike with calls, the owner gains nothing if the price goes down. Instead, he loses what he paid for the option less whatever gain he made selling the shares at a higher price than the strike price.

Swaps: Swaps involve two counterparties who exchange cash flows over some period of time. They differ from forward contracts because there is no physical transfer of assets involved; instead, each party agrees to perform obligations based on the terms of the swap agreement. One side makes payments to another counterparty. These payments occur according to prearranged schedules called legs. Each leg consists of one or more payments which begin at different times and end at different dates. When all the scheduled payments have occurred, the swap ends. Swap agreements typically specify whether either party is obligated to make payments even after the swap expires.

 The term “swap” refers to a number of related transactions including currency forwards, basis swaps, cross currencies swaps and credit default swaps. CFs are similar to futures except that they do not require delivery of the underlying product. Basis swaps provide protection against fluctuations in foreign exchange rates. Cross currencies swaps protect against fluctuation in multiple currencies. Credit default swaps are insurance policies protecting borrowers against defaults on their debt instruments. The CDS can be used as a hedge tool to reduce exposure to risk associated with owning bonds issued by companies whose financial condition might deteriorate.

A bond is simply a loan where you give your creditor something worth having in return for the use of funds. Bonds come in many forms such as government bonds, corporate bonds, municipal bonds, mortgage backed securities, asset backed securities, etc.

How Do Derivatives Work?

When we talk about derivatives, it helps to understand how these products work. A derivative contract represents an economic relationship between two parties rather than a direct transaction involving just those two entities. In this case, the buyer pays the seller a premium to enter into the deal. This payment covers both sides of the trade so neither has to worry about making sure the other gets paid back. It also means that when the contract comes due, the buyer owes the seller the agreed upon sum plus interest. If the value of the underlying instrument falls short of the original expectation, then the buyer suffers losses while the seller receives compensation. Conversely, if the value rises above expectations, then the buyer profits and the seller collects its fee.

What Are Options Contracts Used For?

An options contract allows investors to speculate on future prices without taking ownership of the actual commodity being traded. Instead, they pay money up front to buy the right to purchase shares of stock at a certain price within a specified timeframe. Investors may exercise their option anytime before expiration date, but must decide whether to take advantage of the opportunity before the deadline passes.

An investor could choose to wait until the last minute to see what happens with the market. Or he/she could opt to get out early and avoid any potential loss.

Benefits of Derivatives

There are several benefits to using derivatives.

1. Hedging - Using derivatives can help manage risks associated with investments. By entering into a derivative contract, an individual can limit his/her downside risk and increase his/her upside gain.

2. Leverage – Derivative contracts allow individuals to borrow money to invest in stocks, commodities, real estate, etc. They can leverage themselves because they only have to put down a small amount of cash upfront. As long as the investment returns more than the initial deposit, the trader will make a profit.

3. Arbitrage – When there is no difference in price across different markets or exchanges, arbitragers can earn extra income from trading. However, since most people don't know which way the market will move next, it's difficult to predict exactly when the best time to sell would be. That's why some traders turn to derivatives to hedge against possible fluctuations in exchange rates.

4. Speculation – Some traders like to gamble by speculating on the direction of the market. Since futures contracts represent bets on the future movement of a particular index, they provide opportunities for speculation. Futures contracts can be used to bet on rising or falling indexes.

5. Taxation – The IRS considers all gains made through the sale of assets to be taxable events. But not all gains are created equal. With derivatives, you're able to convert your capital gains into tax-free ordinary income.

6. Diversification – Because derivatives offer exposure to multiple asset classes, they reduce overall portfolio volatility.

7. Liquidity – Derivatives give investors access to financial instruments that might otherwise be unavailable. These include foreign currency forwards, swaps, and options.

8. Risk Management – Derivatives enable companies to protect themselves from unexpected changes in supply and demand. Companies use them to insure themselves against adverse weather conditions, natural disasters, political instability, and even war.

9. Insurance – Many insurance policies require customers to maintain adequate levels of coverage. To do this, insurers often issue "derivatives" called callable bonds. Callable bonds are similar to regular bonds except that they come with additional features such as adjustable maturity dates and redemption provisions.

Cons

Counterparty Risks – If one party defaults on its obligations, then both parties lose their entire investment. This means that if something goes wrong, everyone loses everything. It also makes hedges very risky. For example, suppose I'm holding 10 shares of IBM stock and want to enter into a forward agreement where I'll pay $100 per share at expiration. My counterparty has agreed to deliver 100 shares of IBM stock upon request. In order to cover myself in case my counterpart fails to perform, I need to purchase another derivative contract using the same underlying security. So now I've exposed myself to double the risk: firstly, I could end up losing my original 10 shares should my counterpart fail to meet his obligation; secondly, I may lose out on any gain realized between entering into the two separate agreements.

Market Volatility - Derivatives tend to magnify movements in an underlying instrument. Suppose we have a stock whose value rises steadily over time. A long position in our stock represents ownership of more than 1 unit of the stock. As prices rise, so does the number of units owned. Now let's say we decide to short the stock. We borrow enough shares to offset what we own. Prices fall, but because we sold too many shares, we still owe money on those shares. When prices recover, we must buy back the borrowed shares at today's price. That is why it is important to understand how much leverage you will need when trading certain types of securities. Leverage multiplies every move in the markets.

Conclusion

There are pros and cons for each type of trade. You can't just look at the benefits without considering the risks involved. Before making a decision about whether or not to invest in derivatives, make sure you know exactly what you're getting yourself into. And remember, there's no free lunch!