Derivatives – Futures, Options and Swaps
Welcome to the chapter on Derivatives.
Here, we understand what they are and look at the different types of derivatives including futures, options and swaps.
Before we do so, here are our recommended brokers who can help you invest in futures and options. We suggest you check each one and try at least 2 of them for a few months before you pick one platform for all your investments.
What are Derivatives?
Derivatives are a contract for a future transaction where the price is based on an underlying asset. The underlying asset could be a stock or a market index, an interest-bearing security (i.e. bonds, Treasury bills), a physical commodity or even currency.
Derivatives help reduce risks and uncertainty associated with businesses due to fluctuations in the price of the underlying asset in the future. For example, a multinational company may reduce the risk of exchange rate fluctuations in the future by going ahead with derivative contracts. Similarly, a food processing company may reduce risks from a rise in prices of agricultural commodities in the future with a derivative contract.
The certainty of future prices allows companies to become better at exploring new opportunities, taking more effective actions, and growing their businesses. This ultimately helps to reduce costs for you as a consumer.
The inherent nature of future fluctuations being unpredictable means there is also a large market for investors looking to make money from these fluctuations through derivative contracts.
Types of Derivative Contracts
There are four types of basic Derivative contracts: Forwards, Futures, Options and Swaps.
Futures Contracts
A futures contract is an agreement between two parties to buy or sell an asset at a certain time in future at a certain price. The parties are obligated to fulfil the commitment to buy or sell the underlying asset at the future date. These are traded on exchanges and are standardised contracts.
To understand this better, imagine a food processing company needing wheat at a certain date after 1 month. But the company thinks the price of wheat may rise after a month. So, it will try to enter into a contract with a seller of wheat to buy the wheat from them at the current price but take the delivery later.
The seller, on the other hand, may think that the price of wheat may fall and wants to enter into a contract right now and fix on the current price so that they do not suffer a loss.
Here, both the buyer and the seller stand to gain as the buyer is buying wheat to be delivered at a future date at the current price (which they expect to rise), and the seller is selling at the current price (which they expect to fall).
Forward Contracts
These are similar to Futures but do not trade on the primary exchanges but on over-the-counter (OTC) exchanges. Here promises are made to deliver an asset at a predetermined price at a pre-determined future date. These are customised contracts and happen between two parties based on their needs.
Here the risk is more as the buyer or seller may not be able to meet the obligations stated in the contract. Since it is a contract between specific two parties, it becomes difficult to get out of the contract, unlike a Futures contract that can be traded in the exchange with other parties.
Options Contracts
Options give the buyer a right but not an obligation to buy or sell an asset in the future. It is similar to a Futures Contract as it is an agreement between two parties to buy or sell an asset at a specific price at a predetermined future date. And it is different from a Futures Contract as under an Options Contract there is no obligation to exercise the right to buy and sell. It is an opportunity, not an obligation.
Options are of two types:
- Call Options
- Put Options
Call Options
These give the buyer the right but not the obligation to BUY a given quantity of the underlying asset at a given price on or before a specific future date.
Put Options
Here the buyer gets the right but not the obligation to SELL a given quantity of the underlying asset at a given price on or before a given date.
A good way to remember what they stand for at the beginning when you are just trying to understand derivatives is to remember: In a market, you CALL out to the seller to BUY what they are offering and PUT up your stuff to Sell.
One more thing you need to know in options is the difference between long and short positions.
Long Position
Buying or holding a call or put option is called a long position because the investor owns the right to buy or sell the security to the other investor (called writer) at a specified price.
Short Position
Selling (or writing) a call or put option is the opposite and is called a short position because the writer is obligated to sell the shares to or buy the shares from the long position holder or the buyer of the option.
These positions may be held simultaneously by an investor to balance his risk and get more income from a security. A long stock position is considered bullish as it expects a rise in the price while a short stock position is bearish as it expects a fall.
Swaps
Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They are similar to Forwards in the sense that they are private agreements between two parties.
The two most common types of swaps are Interest Rate Swaps and Currency Swaps.
Interest Rate Swaps
Here the two parties swap cash flows carrying interest in the same currency. The idea is to protect against interest rate fluctuations.
Let us understand this with an example.
Suppose Company Alpha has borrowed Rs. 1 crore at a variable rate of interest. The current interest rate is 8%. Now the management of Alpha may expect the interest rates to rise in the future and would like to reduce their interest outflows by agreeing on a fixed rate of interest.
Now Alpha may create a swap with Company Gamma, which expects the interest rate to fall. They may agree to the terms that Alpha will pay Gamma a 9% fixed interest rate while Gamma will pay Alpha 8% on the same principal, which is what Alpha is paying to its lender. So by paying 1% interest more Alpha is protecting itself against a higher rate of interest.
At the beginning of the swap, Alpha will pay Gamma the 1% difference (9% – 8%) between the two swap rates.
Now, if interest rates rise to 10%, then Gamma would have to pay Alpha the 1% difference between the two swap rates. This means in essence, Alpha is paying only 9% (the interest it is paying the lender, i.e. 10% less the 1% it got from Gamma).
And if interest rates fall so that the variable rate on the original loan is now 7%, Alpha will have to pay Gamma the 2% difference on the loan, which again means it is paying only 9% (the interest it is paying the lender, i.e. 7% plus the 2% it has to give Gamma).
Regardless of how interest rates move, the currency swap would have helped Alpha to change its variable rate loan into a fixed-rate loan.
Currency Swaps
Here, the two parties swap cash flows where the principal and interest are in different currencies. This is to guard against fluctuations in the exchange rate.
Key Terms to Know
Margin Trading
A margin is the collateral that the investor has to deposit to cover the credit risk that their broker is taking for them by allowing them to make investments over and above their account balance. The broker is called the counterparty.
In margin buying the investor buys securities with cash borrowed from a broker, using other securities as collateral. The difference between the value of the collateral securities and the loan has to stay above a minimum margin requirement (called Maintenance Margin) so that the broker is protected against a fall in the value of the securities to the extent that the investor cannot cover the loan.
If the margin amount is reduced due to losses to the Maintenance Margin level, the broker asks the trader to top it up. This is called a Margin Call. The top-up portion is called the Variation Margin.
Long and Short Positions
If an investor has bought and owns all the shares of a stock, she is supposed to have a long position. But if she owes these stocks to someone at the expiry of a derivatives contract but she does not own the stocks as yet, she is said to have a short position. She must buy the stock so she can fulfil the obligation under the contract at the time of settlement.
Summary
Derivatives are perhaps the most complex of all investments. It can take years for an investor to fully understand how the markets work and even then go wrong due to the unpredictability of the future. No one can guess what the future holds, though there are ways to counter risks by taking both positions.
If you are just starting out, then it makes sense to avoid derivatives altogether. But if you are planning to become good at investing and get predictable returns, then it may be a good idea to learn a bit of investing in derivatives before you take the plunge.