Derivatives 101: Overview & Types
A derivative security is a financial instrument whose value depends upon the value of another asset. The main types of derivatives are futures, forwards, options, and swaps.
KEY TAKEAWAYS
- A derivative is a financial instrument that has a value determined by the price of something else.
- Derivative investments are investments that are derived, or created, from an underlying asset.
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How Are Derivatives Used?
Financial derivatives are so effective in reducing risk because they enable financial institutions to hedge; that is, engage in a financial transaction that reduces or eliminates risk.
Here are some other reasons why financial institutions might use derivative.
- To hedge risks
- To speculate (take a view on the future direction of the market)
- To lock in an arbitrage profit
- To change the nature of a liability
When a financial institution has bought an asset, it is said to have taken a long position, and this exposes the institution to risk if the returns on the asset are uncertain. On the other hand, if it has sold an asset that it has agreed to deliver to another party at a future date, it is said to have taken a short position, and this can also expose the institution to risk.
Types of Derivatives
The main types of derivatives are forwards, futures, options, and swaps.
1. Forwards
Forward contracts are agreements by two parties to engage in a financial transaction at a future point in time.
The asset or commodity on which the forward contract is based is called the underlying asset. Every forward contract has both a buyer and a seller. The party that has agreed to buy has what is termed a long position. The party that has agreed to sell has what is termed a short position.
A long position is one that makes money when the price goes up and a short is one that makes money when the price goes down.
Generally, a forward contract does the following:
- Specifies the quantity and exact type of the asset or commodity the seller must deliver.
- Specifies delivery logistics, such as time, date, and place.
- Specifies the price the buyer will pay at the time of delivery.
- Obligates the seller to sell and the buyer to buy, subject to the above specifications.
2. Futures
Agreement to buy or sell an asset for a certain price at a certain time. It is similar to forward contract. Whereas a forward contract is traded over-the-counter, a futures contract is traded on an exchange.
Key Points About Futures:
- They are settled daily.
- Closing out a futures position involves entering into an offsetting trade.
- Most contracts are closed out before maturity.
- They are standardized and have specified delivery dates, locations, and procedures.
3. Options
An option is a derivative contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset by the expiration date at a specified price. Unlike a futures contract, an option need not be exercised.
There are two types of option contracts.
- A call option is a contract that gives the owner the right to buy a financial instrument at the exercise price within a specific period of time.
- A put option is A put option is a contract that gives the owner the right to sell a financial instrument at the exercise price within a specific period of time.
Here are some key terms used to describe options:
- Strike Price: The strike price, or exercise price, of a call option is what the buyer pays for the asset.
- Exercise: The exercise of a call option is the act of paying the strike price to receive the asset.
- Expiration: The expiration of the option is the date by which the option must either be exercised or it becomes worthless.
- Exercise Style: The exercise style of the option governs the time at which exercise can occur. Options can be American or European, which determines how you can enact them. An American option can be exercised at any time during its life. A European option can be exercised only at maturity (The terms European and American, by the way, have nothing to do with geography. European and American options are bought and sold worldwide.)
4. Swaps
Swaps are financial contracts that obligate each party to the contract to exchange a set of payments it owns for another set of payments owned by another party.
There are two basic kinds of swaps:
- Currency swaps involve the exchange of a set of payments in one currency for a set of payments in another currency.
- Interest-rate swaps involve the exchange of one set of interest payments for another set of interest payments, all denominated in the same currency.
A swap is a contract calling for an exchange of payments over time. One party makes a payment to the other depending upon whether a price turns out to be greater or less than a reference price that is specified in the swap contract. A swap thus provides a means to hedge a stream of risky payments.
When the buyer first enters the swap, its market value is zero, meaning that either party could enter or exit the swap without having to pay anything to the other party.
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