What is a derivatives Market?

A derivative is a financial contract to exchange a certain underlying asset at a certain price in a specified future time.

Derivatives can be traded through an exchange or over-the-counter.

An exchange traded derivative is standardized, has no counterparty risk as the parties require to pay an initial deposit to a clearing house, traded within fixed hours, governed by strict rules of how they are traded, there are limited number of derivatives listed on the exchange.

An Over-the-Counter (OTC) derivative is customized between the two parties, the contracts are bilateral thus have counterparty risk, most are traded over the phone, contracts can be traded at any time of day, there is flexibility on how people can trade and more products are available for trading.

There are four common types of derivatives.

Namely,

1. Options
2. Futures
3. Forwards
4. Swaps

1. Options

In the option, the owner has the right, but not the obligation, to buy or sell the underlying asset at a specific time in future at a specific price (strike price).

The strike price is defined as the price at which the holder of an options contract can buy or sell the underlying asset when the option is exercised. It is also known as the exercise price.

Options are exchange traded derivatives. Options have premiums.

There are two types of options:

• A call option which gives the holder the right but not obligation to buy an underlying asset, at a given price on or before a given future date. The buyer of the option is referred to as a long party that is has a long position
• A put option gives the buyer the right but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. The seller of the option is referred to as the short party that it has a short position.

Options can be exercised before or on the expiration date:

• American options allow you to excise before or at the date of expiry.
• European options allow you to only excise at expiry.

How to use options.

Positions that can be taken:

• Long Call: Buy a call option
• Short call: Sell a call option
• Long Put: Buy a put option
• Short Put: Sell a put option

An investor has to determine if they are in the money, at the money or out of the money. This is different for a put and call option. This concept is called moneyness

For a CALL option, price of the underlying asset (S) less the exercise price of the option (X) should be greater than 0. This is because the buyer will have bought the asset at a price lower than the market if it greater than 0.Once you understand this concept , the basic interpretation is

If S-X > 0 , it is in the money and it is exercised.

Is S-X=0 it is at the money and it is not exercised

If S-X< 0 ,it is out of the money and it is not exercised.

For a PUT option, price of the underlying asset (S), less the exercise price of the option (X), should be less than 0. This is because the buyer will have bought the asset at a price lower than the market if it greater than 0.Once you understand this concept , the basic interpretation is

If S-X < 0 , it is in the money and it is exercised.

Is S-X = 0 it is at the money and it is not exercised

If S-X > 0 ,it is out of the money and it is not exercised

2. Futures

Futures are exchange-traded.

Futures are traded in an active secondary market with a clearing house and requires daily cash settlement.

It is a contract between two parties to exchange an underlying asset at a specified price in the future.  It has daily settlement.

As a clearing house is involved, in a futures contracts the two parties will pay initial margin to the clearing house to protect the parties against any default. It is deposited before the trade takes place. There is usually a   maintenance margin that is the minimum amount that must be maintained in a futures account. If at the end of the day the value is below the maintenance margin the account is balanced. The use of clearing house helps mitigate the default risk in a futures contract.

3. Forwards

This is an over the counter derivative. One party agrees to buy the asset at a specified date in future at a specified price.

An investor would enter into this contract to hedge against an existing exposure to risk. Neither party makes an initial payment at the beginning.

The party that agrees to buy the underlying asset has a long forward position and the party that agrees to sell the underlying asset has a short forward position.

If the price of asset increases in the future, the party that is long will have a positive outcome and the party that is short will have a negative outcome.

If the price of the asset decreases in the future, the party that is short will have a positive outcome and the party that is long will have a negative outcome.

4. Swaps

A swap is an arrangement to exchange a series of payments on periodic settlement dates over a certain period of time.
Swaps are over the counter instruments.

Types of swaps include:

A plain vanilla interest rate swap- one party makes fixed interest rate payments on a certain amount in return for a floating interest rate payment from the other party.

Basic swap- trading one set of floating rate payments for another.

Currency swap- a derivative between two institutions to exchange the principal and/or interest payments of a loan in one currency for equivalent amounts, in net present value terms, in another currency

The counterparty who receives the fixed payments and agrees to pay variable rate interest, has to pay variable-rate interest and is the floating rate payer. The payment owed by one party to the other is called the notional principal and is stated in the swap contract.

 Other forms of Derivatives

Credit derivatives

This is a type of protection against default by the borrower. An example of the credit default swap whereby a series of payment is paid to a credit protection sector and in case of a default payment is made to the party.