Derivatives

DEFINITION OF FINANCIAL DERIVATIVES

Derivatives can be defined as financial instruments, the value of which depends on the value of a specific underlying asset (or is derived from it). The most frequent underlying assets include stocks, bonds, commodities, currencies, interest rates or market indices.

The importance of derivatives in the world of finance has been growing in the past 30 years. Financial institutions, banks, corporations regularly and actively trade with various forwards, options, swaps and other derivatives on the exchange or in the OTC market.

CHARACTERISTICS

  • The value of derivatives is derived from the value of a specific underlying instrument. The most frequent underlying assets include stocks, bonds, commodities, currencies, interest rates or market indices.
  • Their principle is a form of a term contract, i.e. there is a certain delay between concluding and realizing the trade. On the contrary, sport contracts are characteristic of matching conclusion and realization of a trade.

CLASSIFICATION

From the perspective of realization of the derivative trade, we distinguish between:

  • Unconditioned term contracts (futures, forwards, swaps), where both contracting parties are obliged to perform the contract and settle it as of the maturity date according to the conditions, and
  • Conditioned term contracts (options), where the buyer is entitled, however not obliged, to perform and settle the contract. As of the maturity date, the buyer either uses the contract or waives it.

Conditioned and unconditioned derivatives can be combined, where such derivatives become the underlying instrument. This way, swap options, futures options, option futures or forward swaps are created.

Depending on the market where derivatives are traded, we distinguish between:

  • Exchange - contract conditions are standardized (maturity term, contract size, etc.)
  • OTC, over-the-counter - trading conditions, as well as the attributes, are not standardized and thus can be tailored for specific business partners.

SHORT AND LONG POSITION

There are two basic trader positions in derivative trading - long position and short position.

  • The trader entered the long position when he bought a derivative contract - thus expecting rising prices of the underlying asset. To realize gains after closing the transaction, the trader must sell at a price higher than the acquisition price.
  • If a trader sells a derivative contract, he gets into short position - the trader speculates in terms of declining price of the underlying asset. Thus, first the trader sells at certain price with anticipated later purchase of goods for a lower price, thus attaining gain.

Purposes pursued by investors with derivatives vary a lot. A smaller portion of players in the market intend to protect their portfolios against losses. These investors use derivatives as insurance (options) or hedging (futures) and they include, for example, managers of investment funds.

However, most players wish to speculate, as derivatives enable high capital gains on a short time span, moreover for relatively low amounts.

FORWARDS

Forwards are binding (unconditioned), non-standardized contracts traded in OTC marketsfor the purpose of buying or selling agreed quantity of a particular underlying asset as of a certain future date at a price agreed when concluding the trade.

One of the parties to a forward contract enters the long position and agrees to buy the relevant underlying asset as of the set date for a particular price. The other party enters a short position and agrees to sell the given asset as of the same date at the same price.

In a forward contract, the buyer is obliged to buy stocks at a previously agreed price as of a previously agreed future date (unconditioned trade).

FUTURES

Futures are binding (unconditioned), standardized (as opposed to forwards) contracts traded on an exchange for the purpose of buying or selling standardized quantity of a particular underlying asset as of a certain future date at a price agreed when concluding the trade.

A party agreeing to buy the underlying asset in the future, i.e. the buyer in the given trade, is in a long position, while the party agreeing to sell the asset in the future, i.e. the seller in the given trade, is said to be in a short position.

To make trading possible, the exchange sets certain standardized features of the given trade. As the two parties in a trade do not know each other, the exchange also provides a system guaranteeing that the trade will be realized.

In real life, the share of actually delivered underlying assets in futures is very low. This is due to the fact that the contracting parties use futures for hedging or speculations and often realize gains before maturity (close the position before maturity).

The underlying asset in futures does not have to be a traditional commodity - they can be currencies, securities or financial instruments and intangible assets or stock indices and interest rates. As futures concern trades taking place in the future, the purpose of the exchange is to act as a middleman who minimizes the risk of default of any of the parties. For this reason, the exchange requires both parties to make an initial deposit, so-called margin. Also, with regard to the fact that prices of futures generally change on a daily basis, the difference between the previously agreed price and the day price of the futures is settled daily. The exchange uses funds from the margin account of one of the parties and deposits them in the account of the order to let each party reach the relevant daily loss or profit. Once the margin account drops below a certain value, the account owner is called to add funds to the account. This process is known as marking to market.

SWAPS

Swaps are contracts between two parties concerning the exchange of financial flows in the course of a given period.

Usually, at a time when the contract starts, at least one of these series of financial flows is determined by a random or uncertain variable, such as an interest rate, exchange rate, stock price or commodity price.

For example, in the case of an interest rate swap, X undertakes to pay fixed interest of 3% of CZK 1,000,000 every year to Y for the next 4 years. On the other hand, Y undertakes to pay variable interest (such as EURIBOR + 1% of CZK 1,000,000), also for 4 years. If EURIBOR is 3% after the first year, X should be paying CZK 30,000 and Y CZK 40,000. Hence, the difference in the amount of CZK 10,000 is paid by Y to X.

In the case of a currency swap, cash flows depend on the value of foreign currencies.

The previously agreed price, at which the option holder may buy (in the case of a call option), or sell (in the case of a put option) the underlying asset is called the strike price. The buyer is deemed to have exercised his option if exercising the right to buy the underlying asset (call option) or to sell it (put option).

OPTIONS

A person buying an option acquires the right (however NOT an obligation)  to

buy (call option)                               or                                 sell (put option)

a certain underlying asset during a certain period (American option) or at expiration of a period (European option), and pays the option premium for this right. The seller (writer of the option) is obliged to buy (put) or sell (call) the underlying asset at a previously determined strike price, if the buyer will exercise the option.

A person buying an option must pay a certain price for the right to the writer of the option (seller). The price of the option is also called "option premium".

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