There are total of 20 Chapters in 7
modules, covering all the essential topics in finance, economics, ethics and
regulations. This series of articles
will highlight the core knowledge of each chapter.
Chapter 11 provides an overview of derivatives.
The learning outcome of chapter 11 is as follows:
·
Define
a derivative contract;
·
Describe
uses of derivative contracts;
·
Describe
key terms of derivative contracts;
·
Describe
forwards and futures;
·
Distinguish
between forwards and futures;
·
Describe
options and their uses;
·
Define
swaps and their uses.
Derivatives are contracts that derive their value
from the performance of an underlying asset, event, or outcome—hence their
name. Since the development of derivatives contracts to help reduce risk for
farmers, the uses and types of derivatives contracts and the size of the
derivatives market have increased significantly. Derivatives are no longer just
about reducing risk, but form part of the investment strategies of many fund
managers.
The size of the global derivatives
market is now around $800 trillion. To put this figure in context, the combined
value of every exchange-listed company in the United States is around $23
trillion. Given their sheer volume, derivatives are very important to financial
markets and the work of investment professionals.
Derivatives can be created on any asset,
event, or outcome, which is called the underlying. The underlying can be
a real asset, such as wheat or gold, or a financial asset, such as the share of
a company. The underlying can also be a broad market index, such as the S&P
500 Index or the FTSE 100 Index. The underlying can be an outcome, such as a
day with temperatures under or over a specified temperature (also known as
heating and cooling days), or an event, such as bankruptcy. Derivatives can be
used to manage risks associated with the underlying, but they may also result
in increased risk exposure for the other party to the contract.
Let us continue the story of the wheat
farmer. The farmer anticipates having at least 50,000 bushels of wheat
available for sale in mid-September, six months from now. Wheat is currently
trading in the market at $9.00 per bushel, which is the spot price. The farmer
has no way of knowing what the market price of wheat will be in six months. The
farmer finds a cereal producer that needs wheat and is willing to contract to
buy 50,000 bushels of wheat at a price of $8.50 per bushel in six months. The
contract provides a hedge for both the farmer and the cereal producer. A
hedge is an action that reduces uncertainty or risk.
But what if the farmer cannot find
someone who actually needs the wheat? The farmer might still find a
counterparty that is willing to enter into a contract to buy the wheat in the
future at an agreed on price. This counterparty may anticipate being able to
sell the wheat at a higher price in the market than the price agreed on with
the farmer. This counterparty may be called a speculator. This counterparty is
not hedging risk but is instead taking on risk in anticipation of earning a
return. But there is no guarantee of a return. Even if the price in the market
is lower than the price agreed on with the farmer, the counterparty has to buy
the wheat at the agreed on price and then may have to sell it at a loss.
Derivatives allow companies and
investors to manage future risks related to raw material prices, product
prices, interest rates, exchange rates, and even uncontrollable factors, such
as weather. They also allow investors to gain exposure to underlying assets
while committing much less capital and incurring lower transaction costs than
if they had invested directly in the assets.
There are four main types of derivatives
contracts: forward contracts (forwards), futures contracts (futures), option
contracts (options), and swap contracts (swaps). Each of these will be
discussed in the following sections. All derivatives contracts specify four key
terms: the (1) underlying, (2) size and price, (3) expiration date, and (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 of underlyings include the following:
·
Agricultural
products (such as wheat, rice, soybeans, cotton, butter, and milk)
·
Livestock
(such as hogs and cattle)
·
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)
·
Other
products (such as electricity or fertilisers)
A derivative’s underlying must be
clearly defined because quality can vary. For example, crude oil is classified
by specific attributes, such as its American Petroleum Institute (API) gravity,
specific gravity, and sulphur content; Brent crude oil, light sweet crude oil,
and crude oil are different underlyings. Similarly, there is a difference
between Black Sea Wheat, Soft Red Winter Wheat No. 1 and No.2, and KC Hard Red
Winter Wheat No. 1 and No. 2.
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. Note that the price specified in the contract is not the
current or spot price for the underlying but a price that is good for future
delivery.
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. If physical delivery to settle is possible, the contract will specify
delivery location(s). Contracts with underlying outcomes, such as heating or
cooling days, cannot be settled through physical delivery and must be settled
in cash. In practice, most derivatives contracts are settled in cash.
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