Derivatives

What are Derivatives?

Derivatives are specialized financial agreements whose value is linked to something else known as the underlying. The underlying asset could be from traditional asset classes like bonds, interest rates, stocks, and credits, or it could be currencies and commodities. In recent years, derivatives have expanded to cover many other market elements such as inflation and volatility.

Types of Derivatives

There are three basic types of derivatives: forwards and futures, swaps, and options.

Forwards and Futures

Forwards and futures are agreements to buy or sell an underlying asset at a future date for a price determined today. Futures are traded on exchanges and are standardized, while forwards are customized contracts traded over the counter (OTC) between two counterparties.

Options

Options provide the buyer with the right, but not the obligation, to buy (call option) or sell (put option) an asset at a predetermined price on or before the contract’s expiration.

Swaps

Swaps involve the exchange of cash flows over a period of time. There are various types of swaps, including:

• Interest Rate Swaps involve exchanging fixed-rate interest payments for floating-rate ones on a specified principal amount. For example, a trader might enter into a swap agreement with a notional value of $100 million, a tenor of 10 years, and a fixed swap rate of 3.86% against SOFR.
• Credit Default Swaps (CDS) are agreements where one party pays a periodic fee in return for a financial safeguard should a third party default on a debt instrument.
•  Commodity Swaps allow for the exchange of a fixed commodity price, such as gold or oil, for its variable market price over time.
• Equity swaps exchange the returns on equity assets like stocks and indices typically for fixed or floating interest payments. These swaps serve both speculative purposes and as hedging tools to manage financial exposure.
• FX swaps combine a spot foreign exchange transaction with a forward transaction. These instruments are particularly useful for managing short-term liquidity needs in various currencies.

How Derivatives Work

Derivatives facilitate the trading of risk associated with an underlying asset without necessitating the trading of the asset itself. For example, a forward contract involves a trader agreeing to buy or sell an asset at a future date for a predetermined price. The value of the derivative is linked to the price movements of the underlying asset.

Uses of Derivatives

Derivatives can be used for speculation and hedging:

Speculation

Traders use derivatives to bet on the future direction of market prices to earn returns. For example, a trader might buy a forward contract predicting an upswing in oil prices.

Hedging

This involves using derivatives to offset potential losses in an investment by taking an opposite position in a related derivative. For instance, a company might use a forward contract to lock in the cost of oil to protect against rising prices.

Risks Associated with Derivatives

Derivatives come with several risks:

• Market Risk: The risk that the value of the derivative will fluctuate due to changes in the underlying asset’s price.
• Counterparty Credit Risk: The risk that one party in the transaction will fail to fulfill their obligations. This risk is particularly pronounced in OTC derivatives.
• Settlement Risk: The risk that a counterparty defaults during the settlement phase of a transaction.

Benefits of Derivatives

Derivatives offer several compelling benefits that make them valuable tools in financial markets. Here are some of the key advantages:

Facilitating Risk Trading: Derivatives allow for the trading of risk associated with an underlying asset without necessitating the trading of the asset itself. This capability translates into several impactful benefits when compared with direct positions in the underlying asset.

Leverage: One of the foremost benefits of derivatives is the heightened ability and breadth of choice they offer to market participants. Embedded leverage is a prime example of this flexibility in action. For instance, in a forward contract for WTI Oil, the trader agrees to purchase 10,000 barrels with settlement due in three months. The initial capital outlay for entering into a derivatives position is often just a fraction of the notional value of the underlying asset. This leverage can amplify potential returns significantly when trading with speculative intent.

Simplified Short Selling: Derivatives streamline the process for establishing short positions, which are positions that make gains when asset prices fall. Shorting the physical commodity can be impractical or even impossible, but derivatives provide a more convenient route since they negate the need for complex security lending arrangements.

Risk Management: Derivatives enable the isolation and management of specific risks inherent to an asset. For example, an investor holding a fixed coupon corporate bond can use derivatives to hedge away the interest rate risk exposure on the bond while speculating on the issuer’s credit risk in isolation.

Cost-Efficient Hedging: In certain scenarios, derivatives can offer cost-efficient hedging alternatives. For instance, an investor with a significant stake in a diversified portfolio anticipating a short-term market dip can use a short position in S&P 500 futures to consolidate the hedging action into a single, more cost-effective transaction.

Complex Trading Strategies: Derivatives facilitate the crafting of more complex trading strategies, typically involving options. These strategies can include positions that capitalize on volatility, benefiting from significant price movements regardless of the direction of the underlying asset.

Examples of Derivatives

Forwards example, a company agrees to buy corn at a fixed price of $10 per quintal for six months to hedge against potential price increases due to heavy rainfall 3.

Futures example, similar to forwards but traded on an exchange. They are standardized contracts with regulatory oversight 3.

Options example, contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price before a certain date 4.

Swaps example, contracts in which two parties exchange cash flows or other financial instruments. Common types include interest rate swaps and currency swaps

Conclusion

Derivatives are powerful financial instruments that offer significant benefits such as risk management, leverage, and the ability to implement complex trading strategies. However, they also come with inherent risks, including market risk, counterparty credit risk, and settlement risk, which must be carefully managed. Understanding the types, uses, and risks associated with derivatives is crucial for effectively utilizing these instruments in financial markets.

Additional Resources

Credit Facility Agreement

Credit Analyst Course