Derivatives: A derivative is a financial instrument whose value as the name says is DERIVED from the value of an underlying asset. The asset could be anything for e.g. commodities, stocks, Forex etc.
The major derivative products are:
Forwards:
A forwards contract is an agreement to buy/sell at a specific price on a specific date. Now the question is why is it done? The reason is to safeguard from the fluctuation of prices in the future. Let us take the example of a cranberry juice manufacturer and a cranberry supplier.
For the juice manufacturer cranberry is a quintessential raw product.
Suppose the price is 30/Kg.
If the price after 2 months is 36/Kg, it would take a hit on the manufacturers profit by 20%. On the other hand if the price of cranberry becomes 27/Kg it increases the profit by 10% in simplistic terms.
So, the manufacturer here is exposed to what is known as market risk or in simple terms the fluctuation of prices in the commodity of interest.
Therefore, the manufacturer would like to enter into a forwards contract which would specify that he/she will buy 100 Kg of cranberry at 31/Kg after 3 months thus HEDGING itself against the market risk.
But here the condition is that there should be someone to take a reverse position in the contract. That is, there should be a cranberry supplier who will be ready to sell at 31/Kg after 3 months.
The supplier is safeguarding/hedging against a decline in prices whereas the buyer is hedging against a rise in prices.
The supplier profits if the price if the cranberry market price is below 31/Kg and the buyer makes a profit if the market price is greater that 31/Kg.
Futures:
A Forwards contract could be agreed between anyone at whatever price, date, location and other details that they seem fit. Only condition is that both the parties should agree to the contract.
However, A futures contract is more standardized in terms of the contents of the contract which are the the price, quantity, delivery date of the product etc.
Lets take an example of ABC Ltd.
Current price of ABC Ltd is 100.
The buyer of the futures contract would be ready to buy ABC Ltd. shares at 105 after 3 months. For this there should be a seller who is willing to sell ABC Ltd. at 105 after 3 months.
Here the price 105 and suppose the quantity was 250 shares. These figures are decided/regulated by the exchange.
The futures contracts are traded over the exchange.
Risk in forwards and futures: Forwards contract have a inbuilt risk of either party defaulting as it is not regulated. For example, the supplier may deliver the cranberries but the manufacturer may refuse to pay the money or vice versa i.e the supplier would refuse to sell after 3 months at 31/Kg.
However, counter party risk is eliminated in futures as the contracts are well regulated.
Options:
There are two parties involved in option trading namely the buyer of the option and seller of the option. These have to be differentiated from the seller and buyer of the asset.
The seller of the option is also called as the writer of the option.
Options are of two types:
Call Option: The buyer of the call option agrees to buy the asset at a specified price in a particular time period. As usual, there has to be seller/writer for this option who takes the reverse position.
Put Option: The buyer of the put option agrees to sell the asset at a specified price in a particular time period. As usual, there has to be seller/writer for this option. In this case the seller refers to the seller of the option though his position would be buying the asset.
There are 4 terminologies associated with options:
Strike price: The price of buying/selling the asset.
Spot price: The current market price.
Premium: An amount paid to the seller of the option (Explained later).
Expiry period: The period for which the contract can be executed.
CALL OPTION:
Suppose the current price of ABC is 400.The buyer now thinks that after one month the price of ABC would be higher than 420. So he enters into a contract to buy ABC at 400 withing an expiry period of one month. Let's say the premium is 4. So he has to pay 4 per 100 shares to the seller/writer of the call option.
Case 1: Now lets say at the end of the month, the spot price/market price is 390 which is less than 400. So now if the buyer buys at 400 plus 4 premium per 100 shares, he will suffer loss as in the market its available at 390. So the buyer can exit the contract and needs to just pay the premium to the seller/writer.
That's why the name OPTION. The buyer has the option but not the obligation to exercise the contract. He can anytime exit the contract by just paying the premium thus minimizing his losses only to the amount of the premium. In this case the seller profited by earning the premium.
Case 2: Let us the assume now that the spot price is 430. The per share profit is 30 as the strike price/buying price is 400. In this case the buyer will exercise the option and receive the assets at 400 plus the premium.
It is important to note that the seller of the option has the obligation. If the buyer exercises his option, the seller has fulfill his/her end of the contract.
In short if the strike price is greater than spot price, don't exercise the option.
PUT OPTION:
Suppose the current price of ABC is 400. Remember, the BUYER of the put option agrees to SELL the asset at a specified price. Always remember he is referred to as the buyer because he is buying the option though he is selling the asset.
The buyer of the put option believes that within this month the market price of ABC will go below 380 and thus wants to sell at 400 within this month. Consequently, there will be a SELLER/WRITER of the put option who will be ready to BUY at 400.
Case 1: Now lets say at the end of the month, the spot price/market price is 390 which is less than 400. So if the buyer decides to execute the put he would have a profit of 10 per share minus the premium as the market price is 390 and he is selling at 400. Thus he will exercise the option and seller of the put has to buy at 400.
Case 2: Let us the assume now that the spot price is 430. In this case the buyer of the option will make a loss as the market price is 430 and he would be selling at 400- the strike price. So the buyer will decide not to execute the option and will exit the contract by paying the premium to the seller of the option. Whatever happens the seller of the option always gets the premium and the buyer of the option always has the right but not the obligation.
If the spot price is greater than strike price, don't exercise the option.
We will cover swaps in a separate article.
If any improvements/suggestions shoot them in the comments below.
Happy reading :)
2 comments:
Amazong efforts team, keep it up
One small correction I feel is required, in the call option section. The first line should read the current price and not the current call option price.
Similarly, in the put option section as well.
Regards,
Nischint Bhatia.
Thank You Nischint! We will make the correction right away.
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