Introduction to Derivatives

Spot Market

The spot market is a public financial market in which commodities (like agriculture material, mining material etc) or financial instruments (viz. stock, index, currency, interest-rate products) are traded for immediate delivery (say T+2). Buyer and seller agrees upon and contractually bounded on following the parameters:

• quality 
• quantity 
• price 
• transaction 
• delivery.

The spot market can be over-the counter (OTC), exchange or organized market.

 

Derivative Market

In contrast, in derivative market, at the time of trading, buyer and seller agrees upon and contractually bounded on quality, quantity, price and future date of payment and delivery. The value of the traded derivative depends on the value of underlying financial instrument or commodity in the spot market. The derivative market can be over-the-counter (OTC) or exchange.

Long position is an agreement to buy the underlying asset on a certain specified future date for a certain specified price. Short position is the other party and agrees to sell that asset on same future date for the same price. The specified price in a forward/future contract is referred to as the delivery price.

Over-the-counter (OTC) market

A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers. Financial institutions often act as market makers. In OTC market, contracts can be non-standard and participants are free to undertake any mutually attractive deal. However, there is some amount of credit risk that the contract will not be honored.

Exchange-traded market

Open outcry is a method of communication between professionals on exchange which involves shouting and the use of hand signals to transfer information primarily about buy and sell orders. Electronic trading is a mode of trading that uses information technology to bring together a buyer and a seller through electronic media to create a virtual market place. Credit risk is eliminated in exchange traded market. Secondary trading in the security are also possible in exchange.

Types of Derivatives

1. Forward Contracts

A forward contract is an agreement between two parties (viz. buyer and seller) to trade an asset at a certain future time for a certain price. Forward contracts are not traded on an exchange and are traded over-the-counter (OTC) between two financial institutions or between a financial institution and one of its corporate clients. Performing the contract is the obligation to both parties and it involves counter-party risk of default. Forward contracts are particularly popular on currencies and interest rates.

2. Futures Contracts

Like a forward contract, a future contract is an agreement (obligation) to buy or sell an asset for a certain price at a certain time. However, since future contracts are traded on the exchange, it involves minimum three parties (viz. buyer, seller and exchange). The future contracts are standard contact designed by the exchange. The buyer or seller can initiate a new contract or close-out (square-off) their existing contract over the exchange. The profit or loss generated due to trade is settled by the exchange. To trade in the exchange, buyer and seller requires to be associated with the members of the exchange. This eliminates the counter party risk as it there in over-the-counter (OTC) trade.

3. Swaps

A swap is an agreement to exchange cash flows at specified future times according to certain specified rules. Swaps can be considered as summation of forward contracts. For example, converting a liability from fixed rate to floating rate, or, converting an investment from floating rate to fixed rate.

4. Options

A call option is an option to buy a certain asset by a certain date for a certain price. A put option is an option to sell a certain asset by a certain date for a certain price.

The holder of the option is not obliged to honor the contract, whereas the holder of Forward/Futures Contract is obliged to buy or sell the underlying asset. It costs nothing to enter into Forward/Futures Contracts, but for buying options, upfront payment is required.

Examples of call contract can be R &D investment, equity investment, gambiling, lottery, oil drilling, mining. Examples of put contract can be insurance (insurance company -> short put whereas insured person -> long put)

Long Call : buy right to buy.. buyer of underlying asset by choice.. paid the premium in advanced.. they have nothing to loose later... they can only gain then on.. and will never run away or default..

Short Call : sell right to buy.. seller of underlying asset by obligation.. they can default..

Long Put : buy right to sell... seller of underlying asset by choice.. paid the premium in advanced.. they have nothing to loose later... they can only gain then on.. and will never run away or default..

Short Put : sell right to sell.. buyer of underlying asset by obligation.. they can default..

Contango & Normal Backwardation market

Contango Market (Futures price > Spot price): Contango is when the futures price is above the expected future spot price. Because the futures price must converge on the expected future spot price, Contango implies that futures prices are falling over time as new information brings them into line with the expected future spot price.

Normal backwardation Market (Spot price < Futures price): Normal backwardation is when the futures price is below the expected future spot price. This is desirable for speculators who are net-long in their positions and they want the futures price to increase. So, normal backwardation is when the futures prices are increasing.

Types of Traders

1. Hedgers

Hedging are perform to eliminate price risk. Hedgers are essentially spot market players. Hedgers are interested in reducing price risk that they already face in the spot market. For that they have position in derivative contracts and options (as well - they already have position in spot market).

• Forward contracts are designed to neutralize risk by fixing the price that hedger will pay or receive for the underlying asset.
• Future contracts can be used to undertake minimum variation hedging.
• Option strategy enables the hedger to insure itself against adverse exchange rate movements while still benefiting from favorable movements.

Process of hedging
1. There is no assurance that the outcome with hedging will be better than the outcome without hedging. So, the first question that need to be answered whether to hedge or not to hedge the portfolio.
 2. If decided to hedge then, decide whether to long hedge or short hedge.

• Long hedge is done by buyer who want to lock-in the price. Has need to buy... and anticipate price will go up. 
• Short hedge is done by seller who want to lock-in the price 

3. Source items in the spot market and future market Find out the items that economically correlated. and then mathematically correlate them.. When correlated items are NOT there... then find items for cross-hedging.
4. Choose the delivery month as close as possible but later then the expiry date of future contract.

Minimum Variation Hedging: The minimum variance hedge define to be a hedge that takes into account the sensitivity of the underlying position that is being hedged.

Optimal Hedge Ratio = Rho * Sigma-S / Sigma-F

Rho is coefficient of correlation change in spot price and spot price

Sigma-S is variations in spot sigma 

2. Speculators

When hedging is not done, it's speculation. Speculators wish to take a position in the market either by betting that the price will go up or down. Futures and options can be used for speculation - when a speculator uses futures then the potential gain or loss is high whereas when a speculator uses options, speculator’s loss is limited to the amount paid for the option.

3. Arbitrageurs

Arbitrage involves locking in a risk-less profit by simultaneously entering into transactions in two markets. Arbitrageurs take advantage of a price difference in the same assets or assets with similar cash-flows between two markets.