Introduction to
Derivatives
The term ‘Derivative’ stands
for a contract whose price is derived from or is dependent upon an underlying
asset. The underlying asset could be a financial asset such as currency, stock
and market index, an interest bearing security or a physical commodity. Today,
around the world, derivative contracts are traded on electricity, weather,
temperature and even volatility.
According to the Securities
Contract Regulation Act, (1956) the term “derivative” includes:
(i) A security derived from a
debt instrument, share, loan, whether secured or unsecured, risk instrument or contract
for differences or any other form of security;
(ii) A contract which derives
its value from the prices, or index of prices, of underlying securities.
Types of Derivatives:
1. OTC (Over the Counter) OTC Derivatives are contracts
that are traded/negotiated directly between the contracting parties. The OTC Derivative market is the largest
market for derivatives and it is also the most unregulated. There is always an
inherent risk of either of the parties not honouring the agreement.
2. ETD (Exchange Traded Derivatives) ETD are those that are traded via
regulated/specialized trading exchanges. A derivative exchange acts as the intermediary for
all transactions and requires an initial margin to be put up by both the
parties of the trade to serve as a guarantee. In India NSE is one of the
largest ETD exchange.
Types (Components or Instruments) of Derivative Contracts
Derivatives comprise four
basic contracts namely Forwards, Futures, Options and Swaps. Over the past
couple of decades several exotic contracts have also emerged but these are
largely the variants of these basic contracts. Let us briefly define some of
the contracts:
a.
Forward
Contracts: A forward contract is an agreement to buy
or sell an asset on a specified date for a specified price. One of the parties
to the contract assumes a long position and agrees to buy the underlying asset
on a certain specified future date for a certain specified price. The other
party assumes a short position and agrees to sell the asset on the same date
for the same price. Other contract details like delivery date, price and
quantity are negotiated bilaterally by the parties to the contract. The forward
contracts are normally traded outside the exchanges.
The salient features of
forward contracts are as given below:
Ø
They
are bilateral contracts and hence exposed to counter-party risk.
Ø
Each
contract is custom designed, and hence is unique in terms of contract size, expiration
date and the asset type and quality.
Ø
The
contract price is generally not available in public domain.
Ø
On
the expiration date, the contract has to be settled by delivery of the asset.
Ø
If
the party wishes to reverse the contract, it has to compulsorily go to the same
counter-party, which often results in high prices being charged.
b.
Future
Contract: A futures
contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. But unlike forward contracts, the
futures contracts are standardized and exchange traded. To facilitate liquidity
in the futures contracts, the exchange specifies certain standard features of
the contract. It is a standardized contract with standard underlying
instrument, a standard quantity and quality of the underlying instrument that
can be delivered, (or which can be used for reference purposes in settlement)
and a standard timing of such settlement. A futures contract may be offset
prior to maturity by entering into an equal and opposite transaction. The standardized
items in a futures contract are:
Ø
Quantity
of the underlying
Ø
Quality
of the underlying
Ø
The
date and the month of delivery
Ø
The
units of price quotation and minimum price change
Ø
Location
of settlement
c.
Option Contracts: Option is
basically an instrument that is traded at the derivative segment in stock
market. Option is a contract between the buyer and seller to buy or sell a one
or more lot of underlying asset at a fixed price on or before the expiry date
of the contract. While buying an option a contract the buyer has the right to
exercise the option within the stipulated time period but he or she is not
bound to exercise that option. On the other hand if the buyer is willing to
exercise the option the seller is bound to honor that contract. In option
trading the price that is agreed up on for trading is called the strike price
and the date on which the option contract is going to expire is called the
expiration time or expiry. There can be different underlying assets for which options
are traded including stocks, index, commodity, derivative instrument like the
future contract and so on.
Types of option contract – There are mainly two types of option
contacts that you can buy or sell at the stock market – ‘Call Option’ and the ‘Put
Option’.
Call Option –
When you are buying a call option it will give you the right to buy the
underlying asset at the strike price within the stipulated time period. The
option writer, who is creating the call option, will have the obligation to
sell the asset if you are willing to buy as per the contract. For buying the
call option you will have to pay the premium price of the contract to the
option writer.
Put Option –
A put option is the opposite of the call option. When you are buying a put
option it will give you the right to sell off the asset in the strike price on
or before the expiry of the option contract. While you will have the freedom to
either honor the put option or ignore it, the seller of the put option will be
legally bound to buy the put if you are willing to sell.
d.
Swaps: A swap is nothing but a barter or exchange but it
plays a very important role in international finance. A swap is the exchange of
one set of cash flows for another. A Swap is an agreement
between two parties to exchange future cash flows according to a predefined
formula. These streams of cash flow are called the "Legs" of the
swap. Usually, when the swap contract is formed at least one of these series of
cash flows are determined by a random or uncertain value like interest rate or
equity price etc. Most swap contracts are traded OTC which are tailor
made for the counter parties. Some are also traded in organized exchanges. The
four generic types of swaps are:
1. Interest rate swaps
2. Currency swaps
3. Equity swaps &
4. Commodity swaps
Participants in Derivative Market
Derivatives have a very wide range of application in
business as well as in finance & banking. There are four main types of
participants in any Derivatives Market. They are:
1. Dealers
2. Hedgers
3. Speculators and
4. Arbitrageurs
A point to note here is that, the same individuals and
organizations may play different roles under different market circumstances.
Let us take a look at each one of them in detail
1.
Dealers: Derivative contracts are bought and sold by dealers
who work for banks and other security houses. Some contracts are traded on
exchanges while others are OTC Transactions. In a large investment bank, the derivatives function is now a highly
skilled affair. Marketing and sales staff speak to clients about what they
want. Experts help to create solutions to those customer requirements using a
combination of forwards, swaps and options. Any risk the bank assumes as a
result of providing such tailor-made products is managed by the traders who run
the banks derivatives books. In the meantime, risk managers keep an eye on the
overall level of the risk the bank is running. Mathematicians, also known as
“Quants” devise the tools required to price the new products created by the experts.
Initially large banks tended to
operate solely as intermediaries in the derivatives market, matching the buyers
and the sellers. Over time, however, they have assumed more and more risk
themselves.
2.
Hedgers: Corporations, investors, banks and governments all use
derivative products to hedge or reduce their exposure to market variables like
interest rates, share prices, bond prices, currency exchange rates, commodity
prices etc. A simple and classic example
would be a farmer who sells a futures contract to lock into a price for the
crop he will deliver in a future date. The buyer might be a food processing company
that wishes to fix the price for taking delivery of the crop in the future or a
“Speculator”
Another typical case is that of a
company due to receive a payment in a foreign currency on a future date. It
enters into a forward contract to sell the foreign currency to a bank and
receive a predetermined quantity of domestic currency. Or, it purchases an
option which gives it the right but not the obligation to sell the foreign
currency at a set rate.
3.
Speculators: Derivatives are nicely suited to speculate on the prices of
commodities and other financial assets or on market variables like interest
rates, market indices etc. Generally speaking, it is much less expensive to
create a speculative position using derivatives than by trading the underlying
commodity or asset. As a result, the potential returns are that much greater.
A classic case is the trader who
believes that the increasing demand or reduced supply is likely to boost the
price of oil. Since it would be too expensive to buy and store actual oil, the
trader buys exchange traded futures (ETFs) contracts agreeing to take delivery
of oil on a future delivery date at a fixed price. If the oil prices rise in
the market, the value of the futures contract will also rise and they can be
sold back into the market at a profit.
In fact, if the trader buys and
then sells a futures contract before they reach the delivery date, the trader
never has to take any delivery of actual oil. The profit from the whole trade
is realized in cash without buying anything.
4.
Arbitrageurs: An Arbitrage is a deal that produces risk-free profits by
exploiting a mispricing in the market. A simple example is when a trader can
buy an asset cheaply in location and simultaneously arrange to sell it at
another location for a higher price. Since such opportunities are unlikely to
exist for a long time, and since arbitrageurs would rush to buy the asset in
the cheap location, the price gap will close very fast.
In the derivatives business,
arbitrage opportunities typically arise because a product can be assembled in
different ways out of different building blocks. If it is possible to sell a
product for more than it costs to buy the constituent parts, then the risk free
profit can be generated. In practice, the presence of transaction costs often
means that only the large market players can profit from such opportunities.
In fact, many of these so called
arbitrage deals constructed in the financial markets are not entirely risk
free. They are designed to exploit differences in the market prices of products
which are very similar but not completely identical. For this very reason, they
are also called as “Relative Value”
Trades.
Swaps and Its Types:
A swap is
nothing but a barter or exchange but it plays a very important role in
international finance. A swap is the exchange of one set of cash flows for
another. A Swap is an agreement
between two parties to exchange future cash flows according to a predefined
formula. These streams of cash flow are called the "Legs" of the
swap. Usually, when the swap contract is formed at least one of these series of
cash flows are determined by a random or uncertain value like interest rate or
equity price etc.
Most swap
contracts are traded OTC which are tailor made for the counter parties. Some are
also traded in organized exchanges. The five generic types of swaps are:
1. Interest
rate swaps
2. Currency
swaps
3. Equity swaps
&
4. Commodity
swaps
1. Interest Rate Swaps: In Interest rate swaps, each party agrees to pay either
a fixed or a floating rate in a particular currency to the other party. The
fixed or floating rate is multiplied with the Notional Principal Amount (NPA)
say Rs. 1 lac. This notional amount is not exchanged between the parties
involved in the Swap. This NPA is used only to calculate the interest flow
between the two parties.
The
most common interest rate swap is where one party 'A' pays a fixed rate to the
other party 'B' while receiving a floating rate which is pegged to a reference
rate like LIBOR. (LIBOR - London Inter
Bank Offer Rate)
For
e.g., a Swap arrangement between two people could be like, 'A' pays a fixed
rate of 3% to 'B' on a principal of Rs. 1 lac every month and 'B' in turn would
pay 'A' at the rate of LIBOR + 0.5%. The cash flow that 'B' can expect from 'A'
is fixed whereas the value that 'A' would receive would vary based upon the
LIBOR. If the LIBOR that month is 2% then 'A' would receive an interest of 2.5%
that month. The fixed rate of 3% is termed as the 'Swap Rate'.
At
the point of Initiation of the Swaps the swap is priced in such a way that the
"Net Present Value" is '0'. If one party wants to pay 50 bps (Basis
points or 0.5%) above the Swap rate, then the other party may have to pay the
same 50 bps above LIBOR.
Net Present Value - NPV is defined as the total present value of a series of cash flows.
The term NPV is used widely in the financial terms and it is used by people to
decide on whether to invest in an instrument or not.
2. Currency Swaps: A currency swap is an agreement between two parties in which one party
promises to make payments in one currency and the other promises to make
payments in another currency. Currency swaps are similar yet notably different
from interest rate swaps and are often combined with interest rate swaps.
Currency swaps
help eliminate the differences between international capital markets. Interest
rates swaps help eliminate barriers caused by regulatory structures. While
currency swaps result in exchange of one currency with another, interest rate
swaps help exchange a fixed rate of interest with a variable rate. The needs of
the parties in a swap transaction are diametrically different. Swaps are not
traded or listed on exchange but they do have an informal market and are traded
among dealers.
A swap is a
contract, which can be effectively combined with other type of derivative
instruments. An option on a swap gives the party the right, but not the
obligation to enter into a swap at a later date.
3. Equity
Swaps: An Equity Swap is a special
type of swap where the underlying asset is a stock or a group of stocks or even
a stock market index. The key differentiator in equity swaps is the fact that
the floating leg of the payment is dependent on the performance of the
underlying stock. One party would receive fixed amounts regularly while the
other would receive a payment depending on the performance of the Stock upon
which the Equity swap is created.
In commodity swaps, the cash
flows to be exchanged are linked to commodity prices. Commodities are physical
assets such as metals, energy stores and food including cattle. E.g. in a
commodity swap, a party may agree to exchange cash flows linked to prices of
oil for a fixed cash flow. Commodity
swaps are used for hedging against Fluctuations in commodity prices or Fluctuations in spreads between
final product and raw material prices (E.g. Cracking spread which indicates the
spread between crude prices and refined product prices significantly affect the
margins of oil refineries)
A Company that uses commodities as input may find
its profits becoming very volatile if the commodity prices become volatile.
This is particularly so when the output prices may not change as frequently as
the commodity prices change. In such cases, the company would enter into a swap
whereby it receives payment linked to commodity prices and pays a fixed rate in
exchange. A producer of a commodity may want to reduce the variability of his
revenues by being a receiver of a fixed rate in exchange for a rate linked to
the commodity prices.
Importance and Limitations of Derivative:
Economic functions of Derivative
In spite of the fear and
criticism with which the derivative markets are commonly looked at, these
markets perform a number of economic functions.
1. Prices in an organized
derivatives market reflect the perception of market participants about the
future and lead the prices of underlying to the perceived future level. The
prices of derivatives converge with the prices of the underlying at the
expiration of the derivative contract. Thus derivatives help in discovery of
future as well as current prices.
2. The derivatives market helps
to transfer risks from those who have them but may not like them to those who
have an appetite for them.
3. Derivatives, due to their
inherent nature, are linked to the underlying cash markets. With the
introduction of derivatives, the underlying market witnesses’ higher trade
volumes because of participation by more players who would not otherwise
participate for lack of an arrangement to transfer risk.
4. Speculative trades shift to a
more controlled environment of derivatives market. In the absence of an
organized derivatives market, speculators trade in the underlying cash markets.
Margining, monitoring and surveillance of the activities of various
participants become extremely difficult in these kinds of mixed markets.
5. An important incidental
benefit that flows from derivatives trading is that it acts as a catalyst for
new entrepreneurial activity. The derivatives have a history of attracting many
bright, creative, well-educated people with an entrepreneurial attitude. They
often energize others to create new businesses, new products and new employment
opportunities, the benefit of which are immense.
In a nut shell, derivatives
markets help increase savings and investment in the long run. Transfer of risk
enables market participants to expand their volume of activity. According to survey conducted in India regarding the sub brokers’ opinion
on the impact of derivatives market on financial market, the result obtained is
given as under.
Derivative securities have
penetrated the Indian stock market and it emerged that investors are using
these securities for different purposes, namely, risk management, profit
enhancement, speculation and arbitrage. High net worth individuals and
proprietary traders account for a large proportion of broker turnover.
Interestingly, some retail participation was also witnessed despite the fact
that these securities are considered largely beyond the reach of retail
investors (because of complexity and relatively high initial investment). Based
on the survey results, the authors identified some important policy issues such
as the need to bring in more institutional participation to make the derivative
market in India more efficient and to bring it in line with the best practices.
Further, there is a need to popularize option instruments because they may
prove to be a useful medium for enhancing retail participation in the
derivative market.
: The
unregulated use of Derivatives can result in huge losses due to the use of
Leverage or Borrowing. It is a well known fact that Derivatives allow investors
to gain huge sums of money from small movements in the underlying asset's
price. However, investors can lose huge amounts of money if the asset moves in
the opposite direction. There have been a lot of instances where investors have
lost significant amounts of money due to Derivatives.
This
is the risk that arises if either of the contracting parties fails to honour
his end of the contract. This is very common in OTC Derivative products.
Since the Derivative markets give an opportunity for an
individual to earn huge profits; it’s often lucrative to small/inexperienced
investors as well. Speculation in the Derivatives
market requires great knowledge
of the market and the future price movements on the
asset over which the derivative is formed to ensure profit. This is
the reason why small investors are generally advised to stay away from them.
Differentiate Between Futures and Forward
At a basic level, futures are also forwards but in a more
organized and regulated form that are executed through exchange. The exchange
acts a guarantee to any counter-party risk. To summarize, the main
differences between forwards and futures are:
1. Futures are insured against counter-party risk whereas in
forwards counter-party risk is the major risk.
2. Futures are traded on an exchange whereas Forwards are
traded over the counter.
3. Futures are standardized financial instruments and the
structure is not altered for the sake of investors. Forwards are tailor made
and can be structured according to the parties involved. For example, futures
are available for a selected expiry dates whereas forwards can be structured
for any specific period of expiry.
4. Futures are more liquid compared to Forwards as the
participants involved in futures market are more.
5. Futures are tradable whereas forwards are contracts
between two parties and hence are not transferrable.
6. In futures the balance is settled everyday (also called
mark to market settlement), whereas in forwards, the balance is settled at a
time (in most of the cases, at the end of the expiry of the contract).
Over the Counter and Exchange Trading Counter
Many financial markets around the world, such as stock
markets, do their trading through exchange. However, forex trading does not
operate on an exchange basis, but trades as ‘Over-The-Counter’ markets (OTC).
The stocks, bonds and other instruments traded on these exchanges are known as
listed securities. Over the counter, or OTC, traded securities
encompass all other financial securities.
Understanding the differences between listed and an OTC transaction is crucial
whether you want to trade shares or sell your firm’s shares to investors.
Difference between Exchange Trading & OTC Trading:
1.
Centralization
of Market:
In a market that operates with exchange trading, transactions are completed
through a centralized source. In other words, one party acts as the mediator
connecting buyers and sellers. There is a specified number of traders that will
trade on that single centralized system. On the other hand, over-the counter
markets are generally decentralized. Here, there are many mediators who compete
to link buyers to sellers. The advantage to this is that it ensures that costs
for intermediary services are as low as possible.
2.
Standardization:
An Exchange Trade is a standard contract wherein Stock exchange
acts as a guarantor for all the trades. But, OTC contracts are customized as
there is no specified guarantor and hence the risk increases a lot.
3.
Counterparty Risk:
When you buy or sell something OTC in a private transaction, there is always
the risk of not getting what you bargained for. The other party might not be
able to deliver the stock, bond or other security within the agreed upon time
frame. It might also deliver a different kind of stock or bond than promised.
These risks are broadly referred to as counterparty risk. In an exchange,
however, counterpart risk is not an issue. The trading occurs through brokers
who are closely monitored by both the exchange and the Securities and Exchange
Commission. Investors buy exchange traded securities with greater confidence
and therefore pay more for such stocks. Because of this, businesses are better
off selling shares through an exchange rather than in a private transaction.
4.
Visibility:
As Exchange market is
an open market wherein there is a clear visibility for prices, start date,
expiration dates & counterparties involved in
a deal etc. But, this is not the case with OTC market as all the terms &
conditions associated with any deal is between the counterparties only.
5.
Parties
Involved: In exchange traded markets, the
exchange is the counterparty to all of the trades. Additionally, there is
price standardization and execution. One negative these exchanges
involves less price competition. OTC, or over the counter markets, have no
centralized trading facility. This promotes heavy competition between
counterparties and lower transaction. The lack
of regulation can introduce fraudulent firms and transaction execution quality
may decrease.
Conclusion:
In exchange markets, there’s a regulator (exchange) through which transactions
are completed, while in OTC market’s there is no regulator. Exchange markets
have less chances of price manipulation, while the many competing traders in
OTC markets can manipulate prices. Exchange markets ensure transaction
security, while OTC markets are prone to fraud and dishonest traders.
The term ‘Derivative’ stands
for a contract whose price is derived from or is dependent upon an underlying
asset. The underlying asset could be a financial asset such as currency, stock
and market index, an interest bearing security or a physical commodity. Today,
around the world, derivative contracts are traded on electricity, weather,
temperature and even volatility.
According to the Securities
Contract Regulation Act, (1956) the term “derivative” includes:
(i) A security derived from a
debt instrument, share, loan, whether secured or unsecured, risk instrument or contract
for differences or any other form of security;
(ii) A contract which derives
its value from the prices, or index of prices, of underlying securities.
Types of Derivatives:
1. OTC (Over the Counter) OTC Derivatives are contracts
that are traded/negotiated directly between the contracting parties. The OTC Derivative market is the largest
market for derivatives and it is also the most unregulated. There is always an
inherent risk of either of the parties not honouring the agreement.
2. ETD (Exchange Traded Derivatives) ETD are those that are traded via
regulated/specialized trading exchanges. A derivative exchange acts as the intermediary for
all transactions and requires an initial margin to be put up by both the
parties of the trade to serve as a guarantee. In India NSE is one of the
largest ETD exchange.
Types (Components or Instruments) of Derivative Contracts
Derivatives comprise four
basic contracts namely Forwards, Futures, Options and Swaps. Over the past
couple of decades several exotic contracts have also emerged but these are
largely the variants of these basic contracts. Let us briefly define some of
the contracts:
a.
Forward
Contracts: A forward contract is an agreement to buy
or sell an asset on a specified date for a specified price. One of the parties
to the contract assumes a long position and agrees to buy the underlying asset
on a certain specified future date for a certain specified price. The other
party assumes a short position and agrees to sell the asset on the same date
for the same price. Other contract details like delivery date, price and
quantity are negotiated bilaterally by the parties to the contract. The forward
contracts are normally traded outside the exchanges.
The salient features of
forward contracts are as given below:
Ø
They
are bilateral contracts and hence exposed to counter-party risk.
Ø
Each
contract is custom designed, and hence is unique in terms of contract size, expiration
date and the asset type and quality.
Ø
The
contract price is generally not available in public domain.
Ø
On
the expiration date, the contract has to be settled by delivery of the asset.
Ø
If
the party wishes to reverse the contract, it has to compulsorily go to the same
counter-party, which often results in high prices being charged.
b.
Future
Contract: A futures
contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. But unlike forward contracts, the
futures contracts are standardized and exchange traded. To facilitate liquidity
in the futures contracts, the exchange specifies certain standard features of
the contract. It is a standardized contract with standard underlying
instrument, a standard quantity and quality of the underlying instrument that
can be delivered, (or which can be used for reference purposes in settlement)
and a standard timing of such settlement. A futures contract may be offset
prior to maturity by entering into an equal and opposite transaction. The standardized
items in a futures contract are:
Ø
Quantity
of the underlying
Ø
Quality
of the underlying
Ø
The
date and the month of delivery
Ø
The
units of price quotation and minimum price change
Ø
Location
of settlement
c.
Option Contracts: Option is
basically an instrument that is traded at the derivative segment in stock
market. Option is a contract between the buyer and seller to buy or sell a one
or more lot of underlying asset at a fixed price on or before the expiry date
of the contract. While buying an option a contract the buyer has the right to
exercise the option within the stipulated time period but he or she is not
bound to exercise that option. On the other hand if the buyer is willing to
exercise the option the seller is bound to honor that contract. In option
trading the price that is agreed up on for trading is called the strike price
and the date on which the option contract is going to expire is called the
expiration time or expiry. There can be different underlying assets for which options
are traded including stocks, index, commodity, derivative instrument like the
future contract and so on.
Types of option contract – There are mainly two types of option
contacts that you can buy or sell at the stock market – ‘Call Option’ and the ‘Put
Option’.
Call Option –
When you are buying a call option it will give you the right to buy the
underlying asset at the strike price within the stipulated time period. The
option writer, who is creating the call option, will have the obligation to
sell the asset if you are willing to buy as per the contract. For buying the
call option you will have to pay the premium price of the contract to the
option writer.
Put Option –
A put option is the opposite of the call option. When you are buying a put
option it will give you the right to sell off the asset in the strike price on
or before the expiry of the option contract. While you will have the freedom to
either honor the put option or ignore it, the seller of the put option will be
legally bound to buy the put if you are willing to sell.
d.
Swaps: A swap is nothing but a barter or exchange but it
plays a very important role in international finance. A swap is the exchange of
one set of cash flows for another. A Swap is an agreement
between two parties to exchange future cash flows according to a predefined
formula. These streams of cash flow are called the "Legs" of the
swap. Usually, when the swap contract is formed at least one of these series of
cash flows are determined by a random or uncertain value like interest rate or
equity price etc. Most swap contracts are traded OTC which are tailor
made for the counterparties. Some are also traded in organized exchanges. The
four generic types of swaps are:
1. Interest rate swaps
2. Currency swaps
3. Equity swaps &
4. Commodity swaps
Participants in Derivative Market
Derivatives have a very wide range of application in
business as well as in finance & banking. There are four main types of
participants in any Derivatives Market. They are:
1. Dealers
2. Hedgers
3. Speculators and
4. Arbitrageurs
A point to note here is that, the same individuals and
organizations may play different roles under different market circumstances.
Let us take a look at each one of them in detail
1.
Dealers: Derivative contracts are bought and sold by dealers
who work for banks and other security houses. Some contracts are traded on
exchanges while others are OTC Transactions. In a large investment bank, the derivatives function is now a highly
skilled affair. Marketing and sales staff speak to clients about what they
want. Experts help to create solutions to those customer requirements using a
combination of forwards, swaps and options. Any risk the bank assumes as a
result of providing such tailor-made products is managed by the traders who run
the banks derivatives books. In the meantime, risk managers keep an eye on the
overall level of the risk the bank is running. Mathematicians, also known as
“Quants” devise the tools required to price the new products created by the experts.
Initially large banks tended to
operate solely as intermediaries in the derivatives market, matching the buyers
and the sellers. Over time, however, they have assumed more and more risk
themselves.
2.
Hedgers: Corporations, investors, banks and governments all use
derivative products to hedge or reduce their exposure to market variables like
interest rates, share prices, bond prices, currency exchange rates, commodity
prices etc. A simple and classic example
would be a farmer who sells a futures contract to lock into a price for the
crop he will deliver in a future date. The buyer might be a food processing company
that wishes to fix the price for taking delivery of the crop in the future or a
“Speculator”
Another typical case is that of a
company due to receive a payment in a foreign currency on a future date. It
enters into a forward contract to sell the foreign currency to a bank and
receive a predetermined quantity of domestic currency. Or, it purchases an
option which gives it the right but not the obligation to sell the foreign
currency at a set rate.
3.
Speculators: Derivatives are nicely suited to speculate on the prices of
commodities and other financial assets or on market variables like interest
rates, market indices etc. Generally speaking, it is much less expensive to
create a speculative position using derivatives than by trading the underlying
commodity or asset. As a result, the potential returns are that much greater.
A classic case is the trader who
believes that the increasing demand or reduced supply is likely to boost the
price of oil. Since it would be too expensive to buy and store actual oil, the
trader buys exchange traded futures (ETFs) contracts agreeing to take delivery
of oil on a future delivery date at a fixed price. If the oil prices rise in
the market, the value of the futures contract will also rise and they can be
sold back into the market at a profit.
In fact, if the trader buys and
then sells a futures contract before they reach the delivery date, the trader
never has to take any delivery of actual oil. The profit from the whole trade
is realized in cash without buying anything.
4.
Arbitrageurs: An Arbitrage is a deal that produces risk-free profits by
exploiting a mispricing in the market. A simple example is when a trader can
buy an asset cheaply in location and simultaneously arrange to sell it at
another location for a higher price. Since such opportunities are unlikely to
exist for a long time, and since arbitrageurs would rush to buy the asset in
the cheap location, the price gap will close very fast.
In the derivatives business,
arbitrage opportunities typically arise because a product can be assembled in
different ways out of different building blocks. If it is possible to sell a
product for more than it costs to buy the constituent parts, then the risk free
profit can be generated. In practice, the presence of transaction costs often
means that only the large market players can profit from such opportunities.
In fact, many of these so called
arbitrage deals constructed in the financial markets are not entirely risk
free. They are designed to exploit differences in the market prices of products
which are very similar but not completely identical. For this very reason, they
are also called as “Relative Value”
Trades.
Swaps and Its Types:
A swap is
nothing but a barter or exchange but it plays a very important role in
international finance. A swap is the exchange of one set of cash flows for
another. A Swap is an agreement
between two parties to exchange future cash flows according to a predefined
formula. These streams of cash flow are called the "Legs" of the
swap. Usually, when the swap contract is formed at least one of these series of
cash flows are determined by a random or uncertain value like interest rate or
equity price etc.
Most swap
contracts are traded OTC which are tailor made for the counterparties. Some are
also traded in organized exchanges. The five generic types of swaps are:
1. Interest
rate swaps
2. Currency
swaps
3. Equity swaps
&
4. Commodity
swaps
1. Interest Rate Swaps: In Interest rate swaps, each party agrees to pay either
a fixed or a floating rate in a particular currency to the other party. The
fixed or floating rate is multiplied with the Notional Principal Amount (NPA)
say Rs. 1 lac. This notional amount is not exchanged between the parties
involved in the Swap. This NPA is used only to calculate the interest flow
between the two parties.
The
most common interest rate swap is where one party 'A' pays a fixed rate to the
other party 'B' while receiving a floating rate which is pegged to a reference
rate like LIBOR. (LIBOR - London Inter
Bank Offer Rate)
For
e.g., a Swap arrangement between two people could be like, 'A' pays a fixed
rate of 3% to 'B' on a principal of Rs. 1 lac every month and 'B' in turn would
pay 'A' at the rate of LIBOR + 0.5%. The cash flow that 'B' can expect from 'A'
is fixed whereas the value that 'A' would receive would vary based upon the
LIBOR. If the LIBOR that month is 2% then 'A' would receive an interest of 2.5%
that month. The fixed rate of 3% is termed as the 'Swap Rate'.
At
the point of Initiation of the Swaps the swap is priced in such a way that the
"Net Present Value" is '0'. If one party wants to pay 50 bps (Basis
points or 0.5%) above the Swap rate, then the other party may have to pay the
same 50 bps above LIBOR.
Net Present Value - NPV is defined as the total present value of a series of cash flows.
The term NPV is used widely in the financial terms and it is used by people to
decide on whether to invest in an instrument or not.
2. Currency Swaps: A currency swap is an agreement between two parties in which one party
promises to make payments in one currency and the other promises to make
payments in another currency. Currency swaps are similar yet notably different
from interest rate swaps and are often combined with interest rate swaps.
Currency swaps
help eliminate the differences between international capital markets. Interest
rates swaps help eliminate barriers caused by regulatory structures. While
currency swaps result in exchange of one currency with another, interest rate
swaps help exchange a fixed rate of interest with a variable rate. The needs of
the parties in a swap transaction are diametrically different. Swaps are not
traded or listed on exchange but they do have an informal market and are traded
among dealers.
A swap is a
contract, which can be effectively combined with other type of derivative
instruments. An option on a swap gives the party the right, but not the
obligation to enter into a swap at a later date.
3. Equity
Swaps: An Equity Swap is a special
type of swap where the underlying asset is a stock or a group of stocks or even
a stock market index. The key differentiator in equity swaps is the fact that
the floating leg of the payment is dependent on the performance of the
underlying stock. One party would receive fixed amounts regularly while the
other would receive a payment depending on the performance of the Stock upon
which the Equity swap is created.
In commodity swaps, the cash
flows to be exchanged are linked to commodity prices. Commodities are physical
assets such as metals, energy stores and food including cattle. E.g. in a
commodity swap, a party may agree to exchange cash flows linked to prices of
oil for a fixed cash flow. Commodity
swaps are used for hedging against Fluctuations in commodity prices or Fluctuations in spreads between
final product and raw material prices (E.g. Cracking spread which indicates the
spread between crude prices and refined product prices significantly affect the
margins of oil refineries)
A Company that uses commodities as input may find
its profits becoming very volatile if the commodity prices become volatile.
This is particularly so when the output prices may not change as frequently as
the commodity prices change. In such cases, the company would enter into a swap
whereby it receives payment linked to commodity prices and pays a fixed rate in
exchange. A producer of a commodity may want to reduce the variability of his
revenues by being a receiver of a fixed rate in exchange for a rate linked to
the commodity prices.
Importance and Limitations of Derivative:
Economic functions of Derivative
In spite of the fear and
criticism with which the derivative markets are commonly looked at, these
markets perform a number of economic functions.
1. Prices in an organized
derivatives market reflect the perception of market participants about the
future and lead the prices of underlying to the perceived future level. The
prices of derivatives converge with the prices of the underlying at the
expiration of the derivative contract. Thus derivatives help in discovery of
future as well as current prices.
2. The derivatives market helps
to transfer risks from those who have them but may not like them to those who
have an appetite for them.
3. Derivatives, due to their
inherent nature, are linked to the underlying cash markets. With the
introduction of derivatives, the underlying market witnesses’ higher trade
volumes because of participation by more players who would not otherwise
participate for lack of an arrangement to transfer risk.
4. Speculative trades shift to a
more controlled environment of derivatives market. In the absence of an
organized derivatives market, speculators trade in the underlying cash markets.
Margining, monitoring and surveillance of the activities of various
participants become extremely difficult in these kinds of mixed markets.
5. An important incidental
benefit that flows from derivatives trading is that it acts as a catalyst for
new entrepreneurial activity. The derivatives have a history of attracting many
bright, creative, well-educated people with an entrepreneurial attitude. They
often energize others to create new businesses, new products and new employment
opportunities, the benefit of which are immense.
In a nut shell, derivatives
markets help increase savings and investment in the long run. Transfer of risk
enables market participants to expand their volume of activity. According to survey conducted in India regarding the sub brokers’ opinion
on the impact of derivatives market on financial market, the result obtained is
given as under.
Derivative securities have
penetrated the Indian stock market and it emerged that investors are using
these securities for different purposes, namely, risk management, profit
enhancement, speculation and arbitrage. High net worth individuals and
proprietary traders account for a large proportion of broker turnover.
Interestingly, some retail participation was also witnessed despite the fact
that these securities are considered largely beyond the reach of retail
investors (because of complexity and relatively high initial investment). Based
on the survey results, the authors identified some important policy issues such
as the need to bring in more institutional participation to make the derivative
market in India more efficient and to bring it in line with the best practices.
Further, there is a need to popularize option instruments because they may
prove to be a useful medium for enhancing retail participation in the
derivative market.
: The
unregulated use of Derivatives can result in huge losses due to the use of
Leverage or Borrowing. It is a well known fact that Derivatives allow investors
to gain huge sums of money from small movements in the underlying asset's
price. However, investors can lose huge amounts of money if the asset moves in
the opposite direction. There have been a lot of instances where investors have
lost significant amounts of money due to Derivatives.
This
is the risk that arises if either of the contracting parties fails to honour
his end of the contract. This is very common in OTC Derivative products.
Since the Derivative markets give an opportunity for an
individual to earn huge profits; it’s often lucrative to small/inexperienced
investors as well. Speculation in the Derivatives
market requires great knowledge
of the market and the future price movements on the
asset over which the derivative is formed to ensure profit. This is
the reason why small investors are generally advised to stay away from them.
Differentiate Between Futures and Forward
At a basic level, futures are also forwards but in a more
organized and regulated form that are executed through exchange. The exchange
acts a guarantee to any counter-party risk. To summarize, the main
differences between forwards and futures are:
1. Futures are insured against counter-party risk whereas in
forwards counter-party risk is the major risk.
2. Futures are traded on an exchange whereas Forwards are
traded over the counter.
3. Futures are standardized financial instruments and the
structure is not altered for the sake of investors. Forwards are tailor made
and can be structured according to the parties involved. For example, futures
are available for a selected expiry dates whereas forwards can be structured
for any specific period of expiry.
4. Futures are more liquid compared to Forwards as the
participants involved in futures market are more.
5. Futures are tradable whereas forwards are contracts
between two parties and hence are not transferrable.
6. In futures the balance is settled everyday (also called
mark to market settlement), whereas in forwards, the balance is settled at a
time (in most of the cases, at the end of the expiry of the contract).
Over the Counter and Exchange Trading Counter
Many financial markets around the world, such as stock
markets, do their trading through exchange. However, forex trading does not
operate on an exchange basis, but trades as ‘Over-The-Counter’ markets (OTC).
The stocks, bonds and other instruments traded on these exchanges are known as
listed securities. Over the counter, or OTC, traded securities
encompass all other financial securities.
Understanding the differences between listed and an OTC transaction is crucial
whether you want to trade shares or sell your firm’s shares to investors.
Difference between Exchange Trading & OTC Trading:
1.
Centralization
of Market:
In a market that operates with exchange trading, transactions are completed
through a centralized source. In other words, one party acts as the mediator
connecting buyers and sellers. There is a specified number of traders that will
trade on that single centralized system. On the other hand, over-the counter
markets are generally decentralized. Here, there are many mediators who compete
to link buyers to sellers. The advantage to this is that it ensures that costs
for intermediary services are as low as possible.
2.
Standardization:
An Exchange Trade is a standard contract wherein Stock exchange
acts as a guarantor for all the trades. But, OTC contracts are customized as
there is no specified guarantor and hence the risk increases a lot.
3.
Counterparty Risk:
When you buy or sell something OTC in a private transaction, there is always
the risk of not getting what you bargained for. The other party might not be
able to deliver the stock, bond or other security within the agreed upon time
frame. It might also deliver a different kind of stock or bond than promised.
These risks are broadly referred to as counter party risk. In an exchange,
however, counterpart risk is not an issue. The trading occurs through brokers
who are closely monitored by both the exchange and the Securities and Exchange
Commission. Investors buy exchange traded securities with greater confidence
and therefore pay more for such stocks. Because of this, businesses are better
off selling shares through an exchange rather than in a private transaction.
4.
Visibility:
As Exchange market is
an open market wherein there is a clear visibility for prices, start date,
expiration dates & counter parties involved in
a deal etc. But, this is not the case with OTC market as all the terms &
conditions associated with any deal is between the counter parties only.
5.
Parties
Involved: In exchange traded markets, the
exchange is the counter party to all of the trades. Additionally, there is
price standardization and execution. One negative these exchanges
involves less price competition. OTC, or over the counter markets, have no
centralized trading facility. This promotes heavy competition between
counter parties and lower transaction. The lack
of regulation can introduce fraudulent firms and transaction execution quality
may decrease.
Conclusion:
In exchange markets, there’s a regulator (exchange) through which transactions
are completed, while in OTC market’s there is no regulator. Exchange markets
have less chances of price manipulation, while the many competing traders in
OTC markets can manipulate prices. Exchange markets ensure transaction
security, while OTC markets are prone to fraud and dishonest traders.
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