This article introduces the concept of derivatrives and explains their utility. It also explains futures and options in detail.
What is a derivative?
The textbook definition of a derivative is: A derivative is an instrument whose value depends on an underlying.
What does it mean in simple terms? Well, the word is kind of self explanatory – the value of a derivative is derived from the value of something. This something is called the Underlying of the derivative.
So, for stock derivatives, the price of the shares of a particular company is the underlying. For an index derivative, the value of the index is the underlying. And for a crude oil derivative, the price of crude oil is the underlying.
As and when the price of the underlying changes, the value of the derivative based on it also changes. Of course, the price also depends on the demand and supply for that derivative, but the primary driver of the price of a derivative is the price of the underlying.
Various Underlying Assets
Markets are very creative! There are people everywhere who spot opportunity to earn money from innovative sources, and therefore, derivatives are available for almost anything!
The primary focus of this article would be derivatives based on equities and equity indices. But the other derivatives available are: Commodity derivatives (crude oil, cotton, etc), bullion derivatives (gold, silver, etc), weather derivatives, and many more.
Types of Derivatives
There are many types of derivatives, but let me talk about the two basic derivatives traded in India.
This is a derivative contract in which the quantity, rate and date of a future purchase is agreed upon today for a given asset.
At this pre-decided date, the buyer of the futures contract gets the delivery of the pre-decided quantity of the given asset at the pre-decided price. Similarly, the seller of the futures contract gives the delivery of the pre-decided quantity of the given asset at the pre-decided price.
In a futures contract, both the buyer and seller are bound to honour their commitment – the buyer has to take delivery, and the seller has to make delivery according to the terms of the contract.
Thus, even if the price of the asset goes down, the buyer has to get the asset from the seller at the pre-decided price. And even if the price goes up, the seller has to give the seller at the pre-decided price.
There is no upfront cost involved in the purchase of a futures contract, apart from brokerage.
A sells the futures contract of Reliance Industries stock to B. Quantity is 200 shares, price is Rs. 3200 and the expiry date is 3 months away.
Now, after 3 months, irrespective of the market price of the stock of Reliance Industries, A would deliver 200 shares of Reliance Industries to B at Rs. 3200.
As the name suggests, here, the buyer has an option to take delivery of the asset, and not the obligation. Thus, if the market price of the asset goes up, and buyer of an option would exercise the option and get profits. But if the market price of the asset goes down, the buyer of the option would not exercise it, and would allow the option to lapse.
Thus, Options are more flexible for the buyers compared to futures. But the seller of the option has the obligation to deliver the assets if the buyer chooses to exercise the option.
In case of options, the pre-decided price for the exchange of asset is called the Strike Price.
One thing to remember though is that in reality, not many people actually exercise their options – people do not actually exchange the asset at the time of exercise. Since the options are traded in the market, instead of exercising them, the buyers just sell them in the market.
The logic behind this – when an option is in the money (that is, when it becomes profitable for the buyer), its option premium or the price goes up. So, one can sell it and make profit instead of exercising it. This is easier, and therefore is done by most people.
American and European Options
The options are of two types – American and European. In American options, the option can be exercised any time upto the settlement date. In European options, the option can be exercised only on the settlement date. Thus, American options are much more flexible (I am introducing this here just as a concept – in India, only American options are traded).
There is a cost involved for options – the buyer of the option has to pay the seller an Option Premium, which is the fee the option seller (also called the Option Writer) gets in return for the one-sided guarantee he extends to the buyer. Since the option writer assumes the risk of the price movement, this fee is well justified.
A writes the option of Reliance Industries stock to B. Quantity is 200 shares, strike price is Rs. 3200 and the expiry date is 3 months away. The option premium is Rs. 25.
Now, during these 3 months, say the price of Reliance Industries stock goes up to Rs. 3400. In this case, B would exercise the option, and would get the shares at Rs. 3200 from A.
Thus, B would make a profit of Rs. 3400 – Rs. 3200 – Rs. 25 (Option premium) = Rs. 175. Similarly, A would make a loss of Rs. 175.
But if the price of Reliance Industries stock remains less than Rs. 3200 for the 3 month duration, B would not exercise the option. In this case, the option buyer B would make a loss equal to the option premium – Rs. 25 in this case, and the option writer would make a profit equal to the option premium – Rs. 25.
Use of Derivatives
The primary use of a derivative is to hedge risk (also called Hedging). When you buy a derivative, you are making a provision that makes your cash flows more certain, or that limits your losses. (I would write another article to illustrate this using calculations).
For example, say you are an exporter, and your earnings are in dollars. Now, you would receive your payment of $15000 after six months. But since you spend in Rupees, you would also like to keep track of your earnings in Rupees.
The value of dollars after six months would decide your actual earning in rupees. Since that is not known right now, it brings uncertainty to your earnings too. Derivatives can be helpful in such a scenario.
You can buy Dollar – Rupee futures contract of $15000 with the rate of Rs. 39.5 for a dollar, and with a validity of 6 months. Thus, you would be certain about your earnings after 6 months – whether the rate after 6 months is Rs. 37 or Rs. 41, you would get Rs. 39.5 for every dollar.
For a business, this kind of certainty in cash flows and earnings can be a very big relief!
Hedging is the primary use of derivatives. But in the market, apart from hedgers, we also have many participants that use derivatives just for investments – people who want to make profits out of the price movement of derivatives – just like stocks.
The presence of such participants is not bad, because they provide liquidity and depth to the derivatives market.
Do come back to read articles describing derivatives in more detail….