Introduction to derivatives

Derivatives are a key tool in risk management. This page introduces key ideas.

A derivative is an asset whose performance (and hence value) is derived from the behaviour of the value of an underlying asset (the "underlying").

The most common underlyings are commodities (e.g. tea, pork bellies), shares, bonds, share indices, currencies and interest rates.

Derivatives are contracts that give the right and sometimes the obligation, to buy or sell a quantity of the underlying or benefit in some other way from a rise or fall in the value of the underlying.

Derivatives include the following:

• Forwards.
• Forward rate agreements ("FRAs").
• Futures.
• Options.
• Swaps.

Forwards, FRAs and futures effectively fix a future price. Options give you the right without the obligation to fix a future price.

The legal right is an asset with its own value that can be bought or sold.

The use of derivatives in managing exchange rate risk and/or interest rate risk can be explored by clicking on the following links:

 Foreign exchange risk management.

Interest rate risk management.

Derivatives are not fixed in volume of supply like normal equity or bond markets. Their existence and creation depends on the existence of counter-parties, market participants willing to take alternative views on the outcome of the same event.

Some derivatives (esp. futures and options) are traded on exchanges where contracts are standardised and completion guaranteed by the exchange. Such contracts will have values and prices quoted. Exchange-traded instruments are of a standard size thus ensuring that they are marketable.

Other transactions are over the counter ("OTC"), where a financial intermediary puts together a product tailored precisely to the needs of the client. It is here where valuation issues and credit risk may arise

Futures contracts

Introduction

A futures contract is an exchange traded forward agreement to buy or sell an underlying asset at some future date for an agreed price.

Futures are like a forward contract in that:

• the company's position is fixed by the rate of exchange in the futures contract
• it is a binding contract.

A futures contract differs from a forward contract in the following ways:

• Futures can be traded on futures exchanges. The contract which guarantees the price (known as the futures contract) is separated from the transaction itself, allowing the contracts to be easily traded.
• Settlement takes place in three-monthly cycles (March, June, September or December). i.e. a company can buy or sell September futures, December futures and so on
• Futures are standardised contracts for standardised amounts. For example, the Chicago Mercantile Exchange (CME) trades sterling futures contracts with a standard size of £62,500. Only whole number multiples of this amount can be bought or sold.

There are two ways of closing a position:

• Deliver the underlying on the maturity date - RARE.
• If futures contracts have been bought, then equivalent contracts can be sold before maturity, resulting in the company having a net profit or loss (and no obligation to deliver).

Hedging is achieved by combining a futures transaction with a market transaction at the prevailing spot rate.

Tick sizes

• A "tick" is the standardised minimum price movement of a futures or options contract.
• Ticks are useful for calculating the profit or loss on a contract.

Margins

A potential problem of dealing in futures is that having made a profit, the other party to the contract has therefore made a loss and defaults on paying you your profit. This is termed "counter party credit risk".

However the buyer and seller of a contract do not transact with each other directly but via members of the market. Therefore the markets Clearing House is the formal counter party to every transaction.

This effectively reduces counter party default risk for those dealing in futures.

As the Clearing House is acting as guarantor for all deals it needs to protect itself against this enormous potential credit risk. It does so by operating a margining system, i.e. an initial margin and the daily variation margin.

The initial margin

When a futures position is opened the Clearing House requires that an initial margin be placed on deposit in a margin account to act as a security against possible default.

The objective of the initial margin is to cover any possible losses made from the first day's trading.

The size of the initial margin depends on the future market, the level of volatility of the interest rates and the risk of default.

• For example, the initial margin on a £500,000 3 month sterling contract traded on LIFFE is £750, i.e. £750/£500,000 = 0.0015%.

Some investors use futures for speculation rather than hedging. The margin system allows for highly leveraged "bets".

The variation margin

At the end of each day the Clearing House calculates the daily profit or loss on the futures position. This is known as "marking to market".

The daily profit or loss is added or subtracted to the margin account balance. The margin account balance is usually maintained at the initial margin.

Therefore if a loss is made on the first day the losing party must deposit funds the following morning in the margin account to cover the loss. An inability to pay a daily loss causes default and the contract is closed, thus protecting the Clearing House from the possibility that the party might accumulate further losses without providing cash to cover them. A profit is added to the margin account balance and may be withdrawn the next day.

Futures hedging calculations

Step 1: Set up the hedge by addressing 3 key questions:

• Do we initially buy or sell futures? e.g. If you want to sell a commodity in the future, then to hedge you should set up a futures position by selling the associated futures contracts for that commodity.
• How many contracts?
• Which expiry date should be chosen? This is usually the date on or nearest after the date of the transaction to be hedged.

Step 2: Contact the exchange. Pay the initial margin. Then wait until the transaction / settlement date.

Step 3: Calculate profit or loss in the futures market by closing out the futures contracts.

Options

Introduction

Options are similar to forwards and other price-fixing contracts but with one key difference.

They give the right but not the obligation to buy or sell the underlying asset at some point in the future at a predetermined rate.

A company can therefore:

• exercise the option if it is in its interests to do so OR 
• let it lapse if the market spot rate is more favourable or if there is no longer a need for the transaction OR
• sell the option, assuming it is a traded contract.

Different types of options

PUT v CALL

• PUT options give you the right to SELL the underlying asset
• CALL options give you the right to BUY the underlying asset

EUROPEAN v AMERICAN

• EUROPEAN options can only be exercised on the expiry date (the last day) of the option
• AMERICAN options can be exercised at any time up to and including the expiry date.
• Note: BERMUDA options are a combination of American and European options and can be exercised on the expiry date  and on certain specified dates that occur between the purchase date and the expiry. 

OTC v TRADED

• OTC options are tailor made (usually sold by a bank) and are normally European options
• TRADED options are standardised both in terms of size and date, are bought or sold on recognised exchanges and are normally American options

Options hedging calculations

Step 1: Set up the hedge by addressing 4 key questions:

• Do we need call or put options?
• How many contracts?
• Which expiry date should be chosen?
• Which strike price / exercise price should be used?

Step 2: Contact the exchange. Pay the upfront premium. Then wait until the transaction / settlement date.

Step 3: On the transaction date, compare the option price with the prevailing market / spot rate to determine whether the option should be exercised or allowed to lapse.

Step 4: Calculate the net cash flows

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