Derivatives
Derivatives is a generic term used to describe futures, options, swaps and various other similar transactions. Apart from interest swaps, most derivative contracts are contracts for differences – the difference between the agreed future price of an asset on a future date and the actual market price on that date.
Futures Contracts
A futures contract is a contract under which one party agrees to deliver to the other party on a specified future date (the “maturity date”) a specified asset at a price (the “strike price”) agreed at the time of the contract and payable on the maturity date. The term “forward contract” is often used in relation to private contracts not transacted through an organised exchange.
The asset may be a commodity or currency or a debt or equity security (or a number or basket of securities), or a deposit of money by way of loan, or any other category of property.
The effect is to guarantee or “hedge” the price. The hedging party protects himself against a loss but also loses the chance to make a profit.
Futures are usually performed (“settled”) by the payment of the difference between the strike price and the market price on the fixed future date, and not by physical delivery and payment in full on that date. Hence they are called “derivatives” because settlement is not by actual full performance of the sale or deposit contract but rather by a difference payment derived from an actual asset and an actual price. The contract is based on or related to or derived from an ordinary commercial contract.
A “spot” contract is one which is to be performed, generally, within two days, i.e. the shortest practicable time to arrange settlement.
Options
A call option is the right (but not an obligation) to acquire an asset in the future at a price (the “strike price”) fixed when the option is entered into.
A put option is the right (but not the obligation) to sell an asset in the future at a price (the “strike price”) fixed when the option is entered into.
The person who is given the option is typically called the “buyer” of the option and the person who grants him the optionis called the “writer” or “seller”. These terms are non-legal vernacular. Thus the buyer of an option is the “buyer” whether or not he has the option to buy or sell under the contract.
An option is “in the money” (i.e. profitable) if, in the case of a put option, the strike price exceeds the market price. Conversely, if the strike price is less than the market price, the option is “out of the money” (i.e. loss-making). In such a case the option-holder will not exercise the option but let it lapse.
Options may be classified according to how they are exercised, i.e. the dates on which the option-holder can call for settlement and convert the option into a firm contract. A “European” option is exercisable only on a fixed future date by reference to prices on that date. An “American” option is exercisable on any day over the agreed fixed period.
The maximum loss that the buyer of an option can suffer is the loss of his premium. Unlike a futures contract, he is not committed to deliver but has merely the option to do so. Conversely, the seller of the option has an unlimited risk because the buyer can, by exercising his option, insist on performance. Hence speculators can expose themselves to risks far greater than a wager, where the money at risk is just the sum wagered.
Options are an inexpensive way of investing. For example, an investor who expects a rise in securities or commodities price can buy a call option for the assets for a premium which will usually be much less than the cost of financing the purchase of the assets themselves. In addition, if the investor bought the assets, he would be exposed to an unlimited drop in their value. In the case of an option, he loses only the premium.
The party which may have to deliver the asset under an option can hedge the risk either by buying the asset under at the inception of the transaction or by entering into a reverse transaction with a third party.
Interest swaps
An interest swap is a contract whereby each party agrees to make periodic payments to the other equal to interest on agreed principal sums and where the interest is calculated on a different basis.
The usual reason for a swap transaction is that one party is a bank of high credit-standing which can borrow at a fixed rate, e.g. by an issue of eurobonds, while the other party is a little known company which cannot borrow cheaply (or at all) in the eurobond market.
Often a bank is interposed as an intermediary between the swapping parties.
The same principle can be applied to commodities or any other asset. Thus an oil producer, fearing a drop in oil prices, may agree to pay to a dealer the floating market price of 100 barrels of oil periodically and the dealer, in return, agrees to pay the oil producer an agreed fixed price for 100 barrels of oil. In this way, the producer guarantees the price of oil which it receives. It simply pays the dealer the market price it receives for the oil on sale to the agreed market and receives a fixed price from the dealer.
A bank may acquire fixed rate bonds and grant an investor a sub-participation on the bonds. The investor deposits an amount equal to the bonds with the bank on terms that the bank will pay the investor amounts equal to principal and interest when received by the bank from the issuer. However the bank pays amounts equal to floating rate to the investor instead of the fixed rate.