Setting the Context
Derivatives are part of the Alternative Investment asset class and provide a very interesting dynamic in hedging investment portfolios. In this week’s article let’s go over “What exactly Derivatives are?”, “What are Forwards, Futures and Options?” and examples of using Forward Contracts and Call Options as hedging instruments.
What is a derivative?
Derivatives are financial instruments that derive their value from the underlying asset. That’s where the “derive” in derivatives comes from! Now, this underlying asset/entity can be anything, for instance, it can be a stock, an entire index, bonds, commodities like corn and gold or even the expected inches of snowfall. Yes, weather derivatives are a thing!
Twenty Second Concept: Central Clearing Party
- A CCP is an organisation which acts as an intermediary in derivative contracts. It acts as a seller to a buyer and a buyer to a seller!
- Suppose Ms A and Mr B enter into a contract, where A is the buyer and B is the seller. The CCP acts as the buyer to B and as the seller to A. This ensures that the terms of the contract are met without any party failing to hold up to their end of the deal.
Where are Derivatives traded?
- Exchange Traded Markets : Derivatives in exchange traded markets, are standardised contracts and are not customisable. The term”exchange” should ring a bell implying it’s a regulated environment. For example, equity derivatives (which derives its value from stocks) are traded on the NSE in form of options and futures.
- Over the Counter (OTC): An OTC is a broker-dealer network and differs from the standardised structure of an exchange. It gives investors an opportunity to invest in companies and assets not listed on a formal centralised exchange. Derivatives traded on an OTC are thereby under lower degree of regulation, have a higher degree of customisation and consequently greater flexibility as compared to derivatives traded on an exchange. The contracts traded on this platform can be a private bilateral agreement between two parties or include a CCP. In India, we have the OTCEI (OTC Exchange of India) which has 115 listings available for trade.
Types of Derivatives
A forward is a financial contract between two parties including an agreement to buy or sell an asset at a specific price at a specific date in the future. The underlying entity can be any asset like – stock indices, currencies or commodities and a key characteristic about a forward is that it’s highly customisable. A forward contract is usually transacted in an OTC market.
Understanding the mechanics of a Forward Contract:
Let’s hypothetically assume that you are a business owner based in India and you’re supposed to be receiving 2 million USD in 2 months as part of your business deal with a US-based MNC. For some reason, you are worried that the INR value is going to fall with respect to USD in the next two months, that means you’ll actually be receiving a lesser amount in INR when you convert the 2 million USD. So what’s your Plan of Action? You get rid of this uncertainty by entering into a foreign currency forward contract. This currency forward contract locks in the exchange rate X for the currency pair INR/USD at a future Date Y. This way you’re certain about the INR value you’ll be receiving when you convert the 2 million USD! Yay. So even if the value of INR declines in the next 2 months, you’re living your best life, because the exchange rate is already locked and you know exactly how much you’re receiving! However, the downside of this forward contract is, IN CASE the INR rises with respect to the USD, then you miss out on the opportunity of receiving more than the current 2 million USD value. But yes, forwards do work as a great hedging instrument!
A Futures contract is basically a standardised version of a Forward Agreement, it is traded on an exchange and consequently subject to greater regulation. Additionally, unlike a Forward contract it is NOT customisable. In case of a Futures contract a Central Clearing Party acts as an intermediary between the buyer and seller. This differentiates futures from forward contracts, which are private bilateral agreements (‘over-the-counter’) between two parties who can freely decide on the terms of the contract themselves.
*A more detailed account on the role of a CCP in Futures contract, margin requirements, mark to market and daily settlement concepts will be covered in a future article.
Example: Commodity futures were introduced in India in October 2018 on Gold, Silver and Energy Futures. Here’s an excerpt from the NSE website:
Options, are a form of derivatives, which derive their value from the underlying asset. Options are of two types – Call and Put. The buyer of the option must pay a certain amount to purchase the option from the seller this is called option premium. The buyer of an option (either call or put) is said to hold the “long-position” and the seller of the option is said to hold the “short-position”.
Call: The buyer has the right but not the obligation to BUY an asset at a specific price (exercise price) on a specific future date (called the expiration date).
Put: The buyer has the right but not the obligation to SELL an asset at a specific price (exercise price) on a specific future date (called the expiration date).
Example: Suppose you’re bullish on Reliance Industries Ltd (current price Rs. 1,579.20) and you expect the price to increase in the coming months. However, you’re not ENTIRELY sure about this, I mean are we entirely sure about anything? Anyway, so you decide to buy a call option on Reliance Industries Ltd, with a strike price of Rs. 1590 whose expiry date is 30th July 2020 by paying an option premium of Rs X. This means after a month, if the price of Reliance goes to say 1600, you’d have the right to buy it at Rs 1590 (the strike price). On the other hand, let’s assume the price of Reliance Industries Ltd tanks against your expectation and goes to Rs 1400, then the only amount you’d lose is the premium Rs. X, the price you paid to purchase the option, which works out much cheaper than actually owning the stock.
And that’s a wrap for this week! 🙂 Stay tuned for new articles every week, simplifying Finance for Gen A to Z.
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