Derivative Markets

Derivative markets are an investment market where the buying and selling of derivatives takes place.

A derivative is a financial instrument whose value is derived from the price of a more basic asset called the underlying asset.

A derivative is a financial instrument whose value is derived from the price of a more basic asset called the underlying asset. The usual textbook definition given for derivatives is something like, "instruments derived from securities or physical market”.

However the word "derivatives" has become a catch-all generic term that has been used to include all types of new (and some old) financial instruments.

The most common types of derivatives that ordinary investors in the market are likely to come across are futures, options and warrants. Beyond this, the derivatives range is only limited by the imagination of investment banks.

It is likely that any person who has funds invested, (e.g. an insurance policy or a pension fund), are exposed to derivatives in some or other way.

Due to their great flexibility, derivatives are used by many different types of investors. Derivatives allow the modern investor the full range of investment strategy: speculation, hedging, arbitrage and all combinations thereof. When one reads about derivatives offering the sophisticated management of risk - this is not just marketing hype. They truly do offer the fund management, insurance and pension industries additional ways to achieve their investment policies.

Types of derivatives:

There are different types of derivatives available in the investment market, but among them the common ones are as follows”

• 1. Forward
• 2. Futures
• 3. Options
• 4. Swap

Forward:

Forward contracts give the owner the right and obligation, to buy or sell a given security at a specified price on (or perhaps before) a specified date.

The long position on the contract agrees to buy the security on the date. They are betting the price will go up.

The short position on the contract agrees to sell the security on the date. They are betting the price will go down.

The basic features of a futures contract are as follows:

• Forward contracts can be worth less than zero. If I have the long position on an expiring forward contract for MGA100 and the price is MGA90, this will cost me MGA10.
• The fact that certain options can go negative mandates margin requirements, where the owner must put money in escrow to prove they can cover the losses.
• Forward contracts are used in commodity trading to hedge the risks of fluctuations.
• Forward contracts are signed between two parties and are not traded on exchanges instead are traded over the counter.
• Closely related with the futures contracts for commodities that are traded on exchanges.
• Futures differ from forward contracts in allowing more flexibility on the timing of when the short position must sell.

Relating Spot and Forward Prices

What is the correct forward price for a commodity whose current (spot) price is ? If the forward price is too high, the money can be borrowed to buy a commodity, and take a short position to guarantee profit to oneself.

Futures:

A futures contract is an agreement to buy from, or sell to, - a futures exchange, - a standard quantity and quality - of a specified asset - on a specific date, - at a price that is determined at the time of trading the contract.

In a world of volatile asset prices, futures contracts fulfill two purposes. Firstly, they allow investors to hedge the risks of adverse price movements. The standardized nature of futures contracts also lead to lower transaction and information costs. Secondly, futures market provides speculators with a high degree of leverage, because the initial margin is relatively small in comparison with the size of the exposure given by the futures contract.

For futures contracts to fulfill these two primary purposes standardized contracts are essential. The standardization of contracts, where everything is fixed except the price, enables the participants to buy and sell them freely on the exchange, where they are traded with precise knowledge regarding the characteristics of the contracts in question.

WHAT ECONOMIC JUSTIFICATION IS THERE FOR FUTURES?

From an economic point of view, the function of futures markets is to allow for the transfer of risk.

Mechanism for the transfer of risks is generally accepted as essentials for the smooth functioning of modern society. Insurance is the most common form of risk transfer: a policy holder (un assure) insures himself against the risk of theft, loss of earnings, accidents, legal action, and a host of other risks, simply by paying an amount of money each month to an insurer.

Share market is also a mechanism for transferring risk. An efficient secondary market allows investors to liquidate their holdings in shares if they are no longer prepared to bear the risks of share ownership. Without the share market, the investor in an enterprise would be in much the same position as a partner in a small firm or shareholder in a proprietary limited company: selling his interest would be difficult because of the problem of locating a buyer and the problem of establishing price.

Futures market serves a vital function within the area of risk transfer. They have the special function of allowing those who do not wish to take risks to nevertheless run business enterprises. A farmer who has acquired considerable skills in agriculture but is totally put off by the prospect of volatile prices in the grain market can use futures to allow him to exercise his growing skills without having to bear all the risks of severe price fluctuations on top of the normal crop risks which he bears anyway. In short, the futures market enables many productive entrepreneurs and businessman to operate without exposing themselves to risks greater than they are willing to bear.

The futures market is also valuable to the economy in that they facilitate "price discovery" and the rapid dissemination of prices.

In a traditional forward market, contracts are not standardized and are entered into directly between buyers and sellers. The prices at which forward contracts are fixed are not relayed to the market because they are "private" deals . Price determination in the overall market is therefore not as efficient as it could be, and buyers and sellers cannot be sure that they are getting the best possible price . In the futures market, by contrast, the competitive nature of the traders ensures that commodities trade at or very close to what the market thinks they are worth, and the smallest market user has as much knowledge as the largest user as to the current value attached to the commodity.

CALCULATION: THE FAIR VALUE OF A FUTURES CONTRACT

The theoretical price of a futures contract can be divided into three main elements:

i. The spot price of the underlying asset;

ii. The financing cost (fc), such as interest, storage or insurance costs for the underlying cash market asset;

iii. The cash flow (cf), if any, generated by the underlying asset.

Futures price = cash price + fc - cf
Where,
fc = financing cost (or gross carry cost)

cf = cash flow of underlying asset (if applicable)The above formula is at times also written as:

Futures price = cash price + net carry cost

where, net carry cost = fc - cf

The net carry cost can be positive or negative depending on the relative size of the financing cost and the cash flow of the underlying asset.

Storable futures are calculated using the carry-cost pricing model, while perishable futures are priced by means of the implied-forward rate pricing model.

Options:

An option to buy is known as a call option, and is usually purchased in the expectation of a rising price; an option to sell is called a put option and is bought in the expectation of a falling price or to protect a profit on an investment. Options, like futures, allow individuals and firms to hedge against the risk of wide fluctuations in prices; they also allow speculators to speculate for large profits with limited liability. It costs nothing upfront to enter into a futures contract, whereas there is an immediate cost of entering into an options contract.

Swaps:

Swap is a derivative, where two counterparties exchange one stream of cash flows against another stream. It is calculated at notional principal amount to hedge certain risk such as interest rate risk or exchange rate risk. There are two different types of swaps available for trading. They are:

Equity swaps those swaps in which the exchange of cash flow is based on the return on the stock market index. For example the counterparties to an equity swap will exchange the dividends from two stocks having almost same value.

Commodity Swaps: The producers need to manage their exposure to fluctuations in the prices for their commodities. They are primarily concerned with fixing prices on contracts to sell their produce. A gold producer wants to hedge his losses attributable to a fall in the price of gold for his current gold inventory. A cattle farmer wants to hedge his exposure to changes in the price of his livestock.