DERIVATIVE CONTRACTS

(or simply derivatives)

Definition: It is a kind of contract that can be traded. The
contract is based upon some underlying assets like
commodities (grains, metals etc.), stocks, bonds, currencies
etc. The contract needs to be settled before or on an expiration
date (also called the maturity). The contracts can be sold or
bought with modified terms of values (payoffs) and expiration
periods.

The value of these contracts is derived from the value of the

underlying assets and the associated fluctuations in the values
of these assets over time.
 Trading of Derivatives
(i) Exchange trading: An exchange is a market where parties
trade standardized contracts whose terms have been
defined by the exchange.
o Initially, the exchanges, on their floor, used to have open
outcry system of trading. The traders used to make hand
signals(or shout) to meet buyers or sellers and then carry out
the type of trades they desired.
o Now, the exchanges have replaced the open outcry system
with the electronic trading system in which traders use a
computer to meet buyers or sellers for the types of trade they
desire.
 Trading of Derivatives continued

(ii) Over-the-counter(OTC) trading: It is also called off-exchange trading.

o In OTC trading, the terms of a contract do not have to be those
specified by an exchange. Market participants are free to negotiate any
mutually attractive deal. OTC trading is done directly between two parties,
without the supervision of an exchange.
o OTC trading is mostly done online or by telephone between parties who
may be two financial firms or their clients etc.
o OTC trading usually involves some credit risk concerns with respect to
the other party. It may happen that a party in a derivatives transaction
will default prior to expiration of the trade and will not make the current
and future payments required by the contract.
 BASIC TYPES OF DERIVATIVE
CONTRACTS (or derivatives)
(i) Forward Contracts
(ii) Futures Contracts
(iii) Options Contracts
(iv) Swaps
 FORWARD CONTRACT
It is the simplest and the oldest form of a derivative contract.
It is an agreement to sale something at a future date or conversely an
agreement to buy something at a future date. The price at which that
transaction will take place is decided in the current time.

A forward contract takes place between two parties privately. Exchange is

not involved into these transactions. So, such contracts happen and are
traded in an OTC market.
Being traded in an OTC market, forward contracts involve credit risk i.e.
one party may default in making payments.
Another point that needs to be noticed is that if these contracts have to be
modified before their expiration, the terms may not be favorable since each
party has one and only option i.e. to persuade or sue the other party.
The details of the forward contracts are privileged information for both the
parties involved and they do not have any legal compulsion to release this
information in the public domain.
 FUTURES CONTRACT(or futures)
A futures contract is very similar to a forwards contract. The similarity lies
in the fact that futures contracts also mandate the sale of commodity at a
future date and at a price which is decided in the current time.
However, futures contracts are listed on the exchange. This means that the
exchange is involved into the transactions. Hence, these contracts are of
standard nature and the agreement cannot be modified in any way.
Exchange contracts come in a pre-decided format, pre-decided sizes and
have pre-decided expirations. Also, since these contracts are traded on the
exchange they have to follow a daily settlement procedure meaning that
any gains or losses realized on this contract on a given day have to be
settled on that very day. This is done to reduce the credit risk from other
party i.e. to preventing other party from default of payments.
An important point that needs to be mentioned is that in case of a futures
contract, they buyer and seller do not enter into an agreement with one
another. Rather both of them enter into an agreement with the exchange.
 OPTION CONTRACTS
In forward contract and futures, parties are bound to buy or sell at a certain date.
However, the options contract binds one party to sell or buy and lets the other
party to sell or buy or not sale or not buy at a later date i.e. at the expiration of the
option. So, one party has the obligation to buy or sell at a later date whereas the
other party can make a choice.
The party that makes a choice has to pay a premium for the privilege.
There are two types of options i.e. call option and put option. Call Option allows
for the choice to buy or not buy something at a later date at a pre decided fixed
price whereas Put Option allows for the choice to sell or not sell something at a
later date at a pre decided fixed price.
Any individual therefore has 4 options when they buy an options contract. They
can be on the long side or the short side of either the put or call option. Like futures,
options are also traded on the exchange.
 SWAPS
Swaps derivatives are contract between two parties to exchange cash in the future
according to a prearranged formula.
Interest Rate Swap: For a notional principal (that does not change hands), one
party, as per convenience, may pay the other at a fixed interest rate each period
and the other party, as per agreement, would pay according to a variable interest
rate per period till the time of settlement.
Currency Swaps : These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than those
in the opposite direction. This can be done between two companies of different
countries to avoid mainly foreign exchange risks.
Swaps can be regarded as a type of forward contract. These are not traded on the
Exchange. These are private contracts which are negotiated between two parties.
Usually investment bankers act as middlemen to these contracts.
Modern derivative contracts include many combinations of these 4 basic derivatives
and result in the creation of extremely complex contracts.
 LONG AND SHORT POSITIONS
The terms long and short refer to whether a trade was entered by buying
first or selling first. A long trade is initiated by buying, with the expectation
to sell at a higher price in the future and realize a profit. A short trade is
initiated by selling first (before buying), with the expectation to buy the
stock back at a lower price and realize a profit.
When a trader is in a long trade, it means they buy an asset, and are hoping
that the price will go up. The sentences used are like "l am long Apple",
which indicates the trader currently owns stock of Apple Inc. , I am "Going
long... that indicates interest in buying an asset.
When going long, profit potential is unlimited, since the price of the asset
can rise indefinitely. The risk in going long is limited to the asset value
going to zero, in that case the trader would lose all value if he does not sale
the derivative to others before its value hit zero.
 LONG AND SHORT POSITIONS cont..
When one is in a short trade, the asset is borrowed initially without any payment
and then sold in the hope that the price will go down in future. After the borrowed
asset (equivalent contract) is sold, and in the future, the asset is bought back at a
lower price and returned to the lending entity. This way the short trader accrues
profit or loss depending upon the over time movement of value of borrowed asset
Phrases used are like "Going short" to indicate their interest in shorting an asset.
On going short, maximum profit is limited to the amount initially received on the
sale on the sale of borrowed asset theoretically assuming that the asset is bought
back at zero price. The risk is theoretically unlimited since the price could rise to
infinity while buying back the equivalent asset.
Most stocks are shortable in the stock market (Exchange). In order to go short in the
stock market, broker (banks, firms, agents etc.) must borrow the shares from
someone who owns the shares. If the broker can't borrow the shares, short that stock
will not be possible. Stocks that just started trading on the Exchange (called Initial
Public Offering stocks, or IPOs) also aren't shortable.
Rising prices and going long is called being bullish, and falling prices and going
short is called being bearish.
Types of Traders in a derivative market
Hedgers: Hedging means reduction of risk. An investor who is looking at
reducing risk is known as a hedger. Hedgers use the derivatives markets
primarily for risk management, the risks may be due to price volatility,
payment defaults etc. For example: Assuming a trader has long position in
shares (has bought and is keeping for longer term), and if market price of
shares drops, the loss could be reduced by the profit achieved from doing
short trading of futures.
Speculators: These are individuals who speculate the future direction of the
markets. They predict whether prices would rise or fall in future and
accordingly buy or sell Futures and Options to try and make a profit from
the future price movements of the underlying asset.
Arbitrageurs: They take positions in markets to earn riskless profits. The
arbitrageurs take short and long positions in the same or different contracts
at the same time to create a position which can generate a riskless profit.
For example: If an asset is priced differently in a spot/cash market (where
commodities and cash are exchanged immediately) and derivatives
markets ( OTC and Exchanges), they would buy the asset priced cheaply
and sell it in the other market to profit.
European(Style) Options and American
(Style) Options
Owners of American-style options may exercise at any time before the
option expires, while owners of European-style options exercise only at
expiration.

European options are usually traded over the counter (OTC), although
some of the European options trade on exchanges. This differs from
American options, which typically trade on exchanges.
Exercising an option on expiration date removes the uncertainty about
possible early execution, a feature that makes the pricing and valuation for
European options simpler than more complicated American options.
While the ability to execute an American option at any time during the
contract provides more flexibility, these options cost a bit more than
European options, all else being equal.
 Types of Prices
Spot or Market Price: A spot contract, or simply spot, is a contract of
buying or selling a commodity or currency for
immediate settlement (payment and delivery) on the spot date, which is
normally two business days after the trade date. The settlement price (or
rate) is called spot price (or spot rate).
A spot contract is in contrast with a forward contract or futures
contract where contract terms are agreed now but delivery and payment
will occur at a future date.
The strike price (or exercise price) of an option is the fixed price at which
the owner of option can choose to buy (in the case of a call option), or sell
(in the case of a put option) the underlying asset.
The strike price may be set by reference to the spot price (market price) of
the underlying assets on the day an option is taken out, or it may be fixed at
a discounted value or at an increased value (premium).
When the contract requires delivery of the underlying asset, the trade will
be at the strike price, regardless of the market price of the underlying asset
at that time.
 Profit Calculation in Options
o There is a Call Option, the premium paid is $10, strike price is $100 and
the spot price is $90, What can be the profit or loss?

o Since it is a Call Option, the choice is to buy or not buy at the expiration.
However, this choice (and hence Option) to buy (Long Position) is
available only after paying the premium of $10 to the other party. The
option contract requires that it has to be bought from the other party at $100
(if bought ) at expiration, despite of the market price being $90. So, the
buyer who is in a Long position would not exercise this option and would
let it elapse to avoid further incurring losses. Hence the Long Position loss
would be the premium paid i.e. $10. While for the Short position (the
default position of the other party) would be a profit of $10.
 Profit Calculation in Options cont
o There is a Put Option, the premium paid is $37, strike price is $200 and the
spot price is $215. What can be the profit or loss.

o Since it is a Put Option, the choice is to sell or not sale. To buy (Long) this
Option, the $37 premium is paid at the beginning to the other party. The
contract requires that it has to be sold (if sold) at $200 to the other party at
expiration, while in the market, at the time of expiration, it is being sold at
$215. Since selling it would cause the loss to further increase by $15, the
Put Option would be allowed to elapse. And the loss incurred would be $37
in the Long position. And for the Short position (which is the default
position of the other party), just opposite would happen i.e.it would be a
profit of $37 for the other party.
 References
www.investopedia.com
www.wikipedia.com
www.finindia.com