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DERIVATIVES

25 Sep, 2018 RBI General Studies

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Derivatives are contracts that derive their value from the performance of an underlying asset, event, or outcome—hence their name.

The Securities Contracts (Regulation) [Act SCRA], 1956, defines derivatives in the following manner.

Derivatives include the following.

  • A security derived from a debt instrument, share, loan (whether secured or unsecured), risk instrument, or contract for differences, or any other form of security.
  • A contract which derives its value from the prices or index of prices of underlying securities.

KEY TERMS OF DERIVATIVES CONTRACTS

All derivatives contracts specify four key terms: the

(1) underlying

(2) size and price

(3) expiration date

(4) settlement

Underlying –

  • Derivatives are constructed based on an underlying, which is specified in the contract.
  • Originally, all derivatives were based only on tangible assets, but now some contracts are based on outcomes.

Examples are -  Agricultural products, Livestock, Currencies, Interest rates, Individual shares and equity indices, Bond indices, Economic factors (such as the inflation rate), Natural resources (such as crude oil, natural gas, gold, silver, and timber), Weather-related, outcomes (such as heating or cooling days) and Other products (such as electricity or fertilisers).

Size and Price –

  • The contract must also specify size and price.
  • The size is the amount of the underlying to be exchanged.
  • The price is what the underlying will be purchased or sold for under the terms of the contract.
  • The price specified in the contract may be called the exercise price or the strike price.

Expiration Date

All derivatives have a finite life; each contract specifies a date on which the contract ends, called the expiration date.

Settlement

Settlement describes how a contract is satisfied at expiration. Some contracts require settlement by physical delivery of the underlying and other contracts allow for or even require cash settlement.

TYPES OF DERIVATIVES

Forwards

A forward contract is an agreement between two parties in which one party agrees to buy from the seller an underlying at a later date for a price established at the start of the contract.

  • Forward contracts transact in the over- the- counter market—that is, the agreement is made directly between two parties, a buyer and a seller—although a dealer may help arrange the agreement.
  • The risk that the other party to the contract will not fulfil its contractual obligations is called counterparty risk.
  • At expiration, forward contracts usually settle with physical delivery.
Futures

A futures contract is similar to a forward contract in that it is an agreement that obligates the seller, at a specified future date, to deliver to the buyer a specified underlying in exchange for the specified futures price.

  • The buyer of the contract is obligated to take delivery of the underlying, and the seller of the contract is obligated to deliver the underlying.
  • The main difference is that futures contracts are standardized contracts that trade on exchanges.
  • The presence of an exchange as an intermediary between buyers and sellers helps reduce counterparty risk.
  • To protect itself against one of the parties defaulting, the exchange typically requires that parties to the contract deposit funds as collateral.
  • The depositing of funds as collateral is called posting margin.
  • The amount deposited on the day that the transaction occurs is called the initial margin. The initial margin should be sufficient to protect the exchange against movements in the underlying’s price.

 

Distinctions between Forwards and Futures

Criteria

Forwards

Futures

Trading and Flexibility of Terms

Forward contracts transact in the over-the-Counter market and terms are customized according to the contracting parties’ needs.

Futures contracts trade on exchanges. Each exchange typically sets the terms of the contracts that trade on it. Futures contracts are standardised regardless of buyers’ and sellers’ specific needs.

Liquidity

Forward contracts trade in the over-the-Counter market and are illiquid.

Futures contracts are relatively liquid; they trade on exchanges and can be bought and sold at times other than initiation.

Counterparty Risk

Counterparty risk is potentially very high in forward contracts. That is, the risk that one party may be unwilling or unable to fulfil its contractual obligations.

Futures contracts have lower counterparty risk. The presence of an exchange or a clearing house as the intermediary for all buyers and all sellers helps reduce counterparty risk.

Transaction Costs

There can be significant costs to arrange a forward contract.

Futures contracts are standardised, transaction costs are relatively low.

Settlement

Forward contracts may settle with physical delivery or cash settlement.

Futures contracts are typically settled with cash.

 

OPTION CONTRACTS

Options give one party (the buyer) to the contract the right to extract an action from the other party (the seller) in the future. In an option contract, the buyer of the option has the right, but not the obligation, to buy or sell the underlying.

  • A buyer chooses whether to exercise an option based on the underlying’s price compared with the exercise price. A buyer will exercise the option only when doing so is advantageous compared with trading in the market, which puts the seller at a disadvantage.
  • The option buyer pays this value, or option premium, to the option seller at the time of the initial contract. The premium paid by the option buyer compensates the option seller for the risk taken.

There are two basic types of options: options to buy the underlying, known as call options, and options to sell the underlying, known as put options.

  • An investor who buys a call option has the right (but not the obligation) to buy or call the underlying from the option seller at the exercise price until the option expires.
  • An investor who buys a put option has the right (but not the obligation) to sell or put the underlying to the option seller at the exercise price until expiration.

Call options protect the buyer by establishing a maximum price the option buyer will have to pay to buy the underlying; the maximum price is the exercise price.

  • A call option is said to be “in the money” if the market price is greater than the exercise price. In this case, the option would be exercised.
  • A call option is “out of the money” if the market price is less than the exercise price. In this case, the option would not be exercised.
  • A call option is “at the money” if the market price and exercise price are the same. In this case, the option may be exercised.

Put options protect the buyer by establishing a minimum price the option buyer will receive when selling the underlying; the minimum price is the exercise price.

  • A put option is said to be “in the money” if the market price is less than the exercise price. In this case, the option would be exercised.
  • A put option is “out of the money” if the market price is greater than the exercise price. In this case, the option would not be exercised.
  • A put option is “at the money” if the market price and exercise price are the same. In this case, the option may be exercised.

 

SWAP CONTRACTS
  • Swaps are typically derivatives in which two parties exchange (swap) cash flows or other financial instruments over multiple periods (months or years) for mutual benefit, usually to manage risk.
  • Similar to forwards and futures, a contract’s net initial value to each party should be zero and as one side of the swap contract gains the other side loses by the same amount.
  • An interest rate swap, the most common type, allows companies to swap their interest rate obligations (usually a fixed rate for a floating rate) to manage interest rate risk, to better match their streams of cash inflows and outflows, or to lower their borrowing costs.
  • A currency swap enables borrowers to exchange debt service obligations denominated in one currency for equivalent debt service obligations denominated in another currency. By swapping future cash flow obligations, the two parties can manage currency risk.

As an example of a currency swap, KFC, a US firm, wants to do business in India. At the same time, Infosys, an Indian firm, wants to do business in the United States. The US firm needs Rupees and the Indian firm needs dollars, so the companies enter into a five-year currency swap for $5 million. Assume that the exchange rate is Rs. 67 per dollar. On this basis, KFC pays Infosys $5 million, and Infosys pays Rs. 335 Lakhs to KFC. Now each company has funds denominated in the other currency (which is the reason for the swap). The two companies then exchange monthly, quarterly, or annual interest payments. Finally, at the end of the five-year swap, the parties re-exchange the original principal amounts and the contract ends.

Credit default swaps

CDS are not truly swaps. Like options, credit default swaps are contingent claims and unilateral contracts. One party buys a CDS to protect itself against a loss of value in a debt security or index of debt securities; the loss of value is primarily the result of a change in credit risk. The seller is providing protection to the buyer against declines in value of the underlying. The seller does this in exchange for a premium payment from the buyer; the premium compensates the seller for the risk of the contract.

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