A derivative instrument, broadly, is a financial contract whose pay off structure is determined by the value of an underlying commodity, security, interest rates, share price index, exchange rate, oil price etc. Just think of a contract whose price or value depends on the underlying. Some of you may be shocked to know that the price of variables can depend on anything; it can as strange as weather or the life of a person.
Derivatives are majorly divided into four classes namely
· Forwards
· Futures
· Options
· Swaps
Now who are the major players in the derivatives market?
1. Hedgers
The party who wants to remove the uncertainty about the price it will have to pay for buying an asset at a particular time in future.
2. Speculators
The party which believes that it can gain by the price movements be it increase or decrease in price
3. Arbitrageurs
Arbitrageurs attempt to profit from pricing inefficiencies in the market by making simultaneous long and short positions and making a risk free profit.
What exactly is an arbitrage?
Arbitrage is an important concept in valuing (pricing) derivative securities. In its purest sense, arbitrage is riskless. If a return greater than the risk-free rate can be earned by holding a portfolio of assets that produces a certain (riskless) return, then an arbitrage opportunity exists.
Arbitrage opportunities arise when assets are mispriced. Trading by arbitrageurs will continue until they affect supply and demand enough to bring asset prices to efficient (no-arbitrage) levels.
There are two arbitrage arguments that are particularly useful in the study and use of derivatives.
The first is based on the “law of one price”. Two securities or portfolios that have identical cash flows in the future, regardless of future events, should have the same price. If A and B have the identical future payoffs, and A is priced lower than B, buy A and sell B. you have an immediate profit, and the payoff on A will satisfy the (future) liability of being short on B.
The second type of arbitrage is used where two securities with uncertain returns can be combined in a portfolio that will have a certain payoff. If a portfolio consisting of A and B has a certain payoff, the portfolio should yield the risk-free rate. If this no-arbitrage condition is violated in that the certain return of A and B together is higher than the risk-free rate, an arbitrage opportunity exists. An arbitrageur could borrow at the risk-free rate, buy the A+B portfolio, and earn arbitrage profits when the certain payoff occurs. The payoff will be more than is required to pay back the loan at the risk-free rate.
Now let us analyze each instrument in a brief
A physical exchange exists for many options contracts and futures contracts. Exchange traded derivatives are standardized and backed by a clearinghouse.
Forwards and swaps are custom instruments and are traded/ created by dealers in a market with no central location. A dealer market with no central location is referred to as an over the counter market. They are largely unregulated markets and each contract is with a counterparty, which may expose the owner of a derivative to default risk.
Forward commitments:
In a forward contract, one party agrees to buy and counterparty to sell, a physical asset or security at a specific price on a specific date in the future. If the future price of the asset increases, the buyer (at the older, lower price) has a gain, and the seller a loss.
Future Contracts:
A future contract is a forward contract that is standardized and exchange-traded. The main differences with forwards are that futures traded in an active secondary market, are regulated, backed by the clearinghouse, and require a daily settlement of gains and losses.
Futures v/s Forwards
• Exchange traded & transparent v/s Private contracts
• Standardized v/s Customized
• Settlement through Clearing House v/s Settlement between Buyers and Sellers
• Require margin payment v/s no margins
• Mark - to - Market margins v/s no margins
• Counter - party risk is absent in Futures (settlement of trades is guaranteed)
• Most settled by offset and very few by delivery v/s most settled by actual delivery.
Swaps:
A swap is a series of forward contracts. In the simplest swap, one party agrees to pay the short-term (floating) rate of interest on some principal amount, and the counterparty agrees to pay a certain (fixed) rate of interest in return. Swaps of different currencies and equity returns are also common.
Options:
An option to buy an asset at a particular price is termed a call option. The seller of the option has an obligation to sell the asset at the agreed-upon price, if the call buyer chooses to exercise the right to buy the asset.
An option to sell an asset at a particular price is termed as a put option. The seller of the option has an obligation to purchase the asset at the agreed-upon price, if the put buyer chooses to exercise the right to sell the asset.
A contingent claim is a claim (to a payoff) that depends on a particular event. Options are contingent claims that depend on a stock price at some future date, rather than forward commitments. While forwards, futures, and swaps have payments that are made based on a price or rate outcome whether the movement is up or down, contingent claims only require a payment if a certain threshold price is broken (e.g., if the price is above X or the rate is below Y). It takes two options to replicate a future or forward.
Criticism and benefits of derivatives:
The criticism of derivatives is that they are “too risky”, especially to investors with limited knowledge of sometimes complex instruments. Because of the high leverage involved in derivatives payoff, they are sometimes likened to gambling.
The benefits of derivatives market are that they:
· Provide price information.
· Allow risk to be managed and shifted among market participants.
· Reduce transactions costs.
In the coming articles we will try and go deeper into each derivative instrument and learn how to diversify your portfolio by using them according to your risk appetite. How to see if a true arbitrage opportunity exist and how to make a risk free profit through these opportunities.
Shubham Goel
IIM Rohtak
