Introduction
To The Basic Concepts Of DERIVATIVES !!!
Derivatives
in general refer to contracts that derive from another - whose value
depends on another contract or asset. Derivatives are essentially devised
as a hedging device to insulate a business from risks over which a business
has no or little control, but in practice, they are also used as yield-kickers.
Where there are risks, there are derivatives to strip the risk and transfer
it. As derivatives are essentially devices of transferring risks, their
types and applications differ based on the type of risk facing a business.
Take, for instance, the following sources of risk and the derivatives
to protect a business against such risks:
Interest rate risk:
Banks and financial institutions face the risk of changes in interest
rates. If a bank has liabilities carrying floating costs and assets
having fixed rates, it faces the risk of an adverse movement, that is,
a decline in interest rates. This risk can be sheltered by writing an
interest rate swap - that is, swapping the floating rate for fixed rates.
Associated with interest rate movements is the basis risk, that is risk
of unpredicted changes in the basis on which interest rates float. Let
us say, a business has loans which are floating with reference to the
LIBOR or EURIBOR, whereas the assets of the business are floating with
reference to US treasuries. To cushion against this risk, the business
may like to swap the basis by entering into a basis swap.
Foreign exchange risk:
If a business has assets or liabilities denominated in foreign currency,
there is a risk of adverse changes in exchange rates. This risk is sheltered
by foreign exchange futures or forward covers.
Commodity risks:
A business having any position on commodities faces risk of changes
in commodity prices. Such risks are also sheltered by futures and forwards
in commodities.
Risk on capital market instruments:
If someone holds equity shares, there is a risk that prices of equity
shares will move up or down. To manage this risk, there are various
futures and options available.
Credit risk:
Yet another risk in all financial transactions is credit risk. Credit
derivatives are used to hedge against credit risk.
Weather risk:
Even something like risk of changes in weather is hedged and transferred.
There is a variety of weather derivatives, that is, instruments that
pay off based on weather changes.
Definition of a derivative:
Accounting standard SFAS 133 defines a derivative thus:
A derivative instrument is a financial instrument or other contract
with all three of the following characteristics:
a. It has (1) one or more underlyings, and (2) one
or more notional amounts or payment provisions or both. Those terms
determine the amount of the settlement or settlements... and in some
cases, whether or not a settlement is required.
b. It requires no initial net investment or an initial
net investment that is smaller than would be required for other types
of contracts that would be expected to have a similar response to changes
in market factors.
c. Its terms require or permit net settlement, it
can readily be settled net by a means outside the contract, or it provides
for delivery of an asset that puts the recipient in a position not substantially
different from net settlement.
Types of derivatives:
The following are the basic types of derivatives:
Forwards:
A forward is a contract to buy a thing or security at a prefixed future
date. The typical usage of a forward would be something like this: a
business having its assets in a local currency has taken a loan repayable
in a foreign currency 6 months hence. There is an exchange rate risk
here: if the local currency suffers against the foreign currency, the
business has to write a loss. To cover against this risk, the business
enters into a forward contract - that is, it agrees today to buy the
foreign currency 6 months hence at prices prevailing today, against
a pre-fixed premium. Obviously, if the perceptions of the seller and
the buyer as to future prices of the foreign currency differ, both will
strike what they perceive is a win-win deal.
Forwards are also quite common in commodities, and can be used either
for speculation or for hedging. Say, XYZ has an order to ship 10000
tons of steel 6 months hence at a prefixed price of say USD 1000 per
ton (by the way, I have no idea of steel prices, this is just an example!).
And XYZ expects the price of steel to go up. So, to hedge against the
price risk, XYZ enters into a forward purchase agreement, for 10000
tons 6 months hence. XYZ's position is now fully hedged: if the price
of steel goes up as expected, XYZ will either claim a delivery from
the forward seller, or a net settlement. If the price comes down, XYZ
will be obliged to settle by making a payment for the price difference
to the forward seller, but will be fully offset by the pre-fixed price
it gets from its own forward sale contract.
Futures:
Futures are more standardised forms of forward contracts and mostly
operate in organised markets. While it is possible to have a forward
contract for any commercial transaction, futures are normally exchange-traded.
Futures contracts are highly uniform contracts that specify the quantity
and quality of the good that can be delivered, the delivery date(s),
the method for closing the contract, and the permissible minimum and
maximum price fluctuations permitted in a trading day.
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