India has the World's Largest Derivatives Exchange by Volume, as per a business article by Bloomberg. This is indeed a remarkable achievement as the NSE’s derivatives volume spiked by 57% to 5.96 billion contracts in 2019 compared to CME’s (Chicago Mercantile Exchange) 4.83 billion contracts.
Yes, it is noteworthy, but you must also know that we contribute a mere 2% in the total revenue of the world’s derivatives market. In fact, the total revenue of NSE’s derivatives stood at $123 million in the June-September quarter of 2019, whereas it reached $1.3 billion and $1.7 billion for CME and ICE (The Intercontinental Exchange), respectively. Amazing facts, right? You are on top of one list and on the bottom of another!
Well, this was just us blabbering about numbers; we don’t have a motive to entice you into reading further just because we topped a list, no. We have a better reason… well, you gotta give us some of your precious time so that we can make you understand the different types of derivatives and a hint on how they can be of great help to you if the art is mastered.
Up for a value addition? Read further.
What are Derivatives?
A contract or an agreement that derives its value or has a value because of some other good involved in the transaction within two parties is known as a derivative. It’s like derivatives have a stock, commodity, or financial asset as ‘underlying’ within the contract. Too complex? Well, it won’t be if you can just comprehend the example we will give you now.
Imagine, you are just hanging out with one of your friends. Good times, uh? Yeah, so out of nowhere, you ended up asking your friend, “Hey dude, let’s make a bet!” to which your friend responded, “yeah, okay! But on what?”. When you specify this; let’s say you asked him to make a bet of Rs.500 on India’s next match with Pakistan on which you are of a point of view that India will score 200 in 20 overs with 5 wickets in hand and your friend is of just a diametrically opposite thought “THEY WON’T”.
By doing so, you have entered a derivative contract. Now you may ask how? Let us extrapolate this for you.
In the universe of finance, the bet you asked for in the very first place had no value of its own. Why? Because there was no reason for it. However, when you mentioned details like possible runs and wickets, the bet started to carry a value of Rs.500. Similar is the mechanism of derivatives.
Here, the IND-PAK match is known as an “underlying”, the Rs.500 is known as “contract value” and the whole of it is known as a derivatives contract because the contract value of Rs.500 has been drawn out or derived from a match between IND-PAK and if this weren’t there, the contract would have had no value.
Types of Derivatives
What you just read was the core of derivatives. Based on this, derivatives are of several types. Following are some of them:
When two parties reach an agreement to buy or sell the underlying asset at an agreed price on a certain date in the future, it is called a forward contract. All forward contracts are tailor-made/ personalised/ customised.
The size of the contract depends on the duration of the contract. The terms of these contracts are either finalized over a call by using OTC (Over-the-Counter) method or even in person. It involves the actual delivery of underlying assets, generally.
The core structure of a future contract is similar to that of a forward contract as there is again an agreement to buy or sell certain goods (underlying assets) between two parties on a pre-decided date for a pre-specified price.
However, future contracts are a more sophisticated version of forward contracts as these are traded on stock exchanges only. The interacting party does not have to meet each other as the trading system does the job of match-making, therefore, allowing you to transact with someone who has an opposite view on the same underlying.
These contacts are ‘standardized’ and don't allow a trader to mould the terms according to their needs. Future contracts in India are ‘Cash-Settled’, which means that it doesn’t involve the physical delivery of an underlying asset or even shares. You are only required to pay the cash difference.
These contracts demand a trader to commit a certain percentage of the total contract value as a safety amount, also known as ‘Margin’, which ensures no default or counterparty risk involved while dealing in futures.
As the name suggests, in this type of derivatives contract, you have an option to either exercise or not exercise the right you have bought.
There are two types of Options:
An option that gives the holder a right to buy the underlying asset for a pre-specified price on a pre-decided date in the future is known as a call option.
For example: Let’s say stock x was trading at Rs. 500, and you receive some positive news (or rumor) about quarterly results. Now you think that this stock will rise above Rs.500 in the next month, but you are unsure. Therefore to protect yourself from a potential heavy downfall in the cash segment, you can buy a call option which will allow you to fix the buying price at Rs.500 for a future date, and if events turn out to be in your favor, you can exercise the call option to get the shares for Rs.500 and then you can sell them in cash segment for a higher price. Profit!
An option that gives the holder a right to sell the underlying asset for a pre-specified price on a pre-decided date in the future is known as a put option.
For example - Let’s say stock Y was trading at Rs.500, and you receive some negative news (or rumor) about quarterly results. Now you think that the stock price of company Y will fall below Rs.500, but you are again not sure about your thoughts. Therefore what you can do now is that you can buy a put option. By doing so, you can fix the selling price at Rs.500 for a future date, and if things go your way, you can exercise your right to sell the stock Y for Rs.500 even if it is trading at Rs.400 in the cash segment. Profit, again!
Having said that, in actual practice, there is no delivery of the underlying, and in fact, the parties settle the differences in cash. Also, the following are additional terms in Option contracts:
To buy the buying right (call option) or selling right (put option), you will be asked to pay a certain amount of money, referred to as ‘premium’.
For a buyer of a call option and put option, the loss is limited to the premium he pays, but there is no limit to the profits.
For a seller (also known as ‘writer’) of a call option and put option, there is no limit to the loss while the profit is limited to the premium paid.
Swap contracts are non-exchange traded derivatives instruments known to be the most complicated type of derivative contracts. However, we believe that they aren’t and very soon you will agree to the same. Let’s understand swaps with an example.
Assume that company A borrows a sum of Rs.1000 from a bank, and as per the terms of the loan, they are asked to pay an interest equal to LIBOR + 2%. Now Company A believes that in the future, LIBOR (London Interbank Offered Rate) will increase from let’s say 2% to 5%, thereby increasing our payable rate of interest on the loan from 4% to 7% as per the formula (LIBOR + 2%). Therefore, to mitigate this risk, Company A enters a Swap agreement.
As the name suggests, something in this is going to be ‘SWAPPED,’ and in this case, it will be the ‘payable interest rate’ equal to LIBOR + 2%. But for what?
It’s simple! For some other interest rate. Since company A thinks their loan burden will increase due to an increase in LIBOR, they agree with company B where the exchange of interest rate happens. So now, as per the terms of the swap contract, company B will fund the ‘floating’ interest rate equal to LIBOR + 2% based on Rs.1000 (notional value), whereas company A will pay company B a ‘fixed’ interest rate of let’s say 5% on the notional value. Company A benefits if LIBOR increases, whereas company B benefits if LIBOR decreases.
Swaps are of various types like:
Interest rate swaps
Credit default swaps
Derivatives have been addressed as a mischievous financial instrument for a long time because of their ability to push your money up and pull your money down rapidly by leveraged positions. Although these are a bit complicated instruments to understand and play with, employing them properly can save institutions and even individual investors from big losses.
But again, investment and trading decisions must be made according to one’s own risk appetite rather than by virtue of an instrument’s features.