Derivatives: An Overview

Derivatives are financial instruments whose value is derived from the price of an underlying asset. This underlying asset can be a variety of financial assets, such as bonds, stocks, or stock market indices, as well as commodities like oil, silver, or wheat. The most common types of derivatives include futures and options.

These instruments serve multiple purposes, including hedging against risk, speculation, and providing cost-effective exposure to markets, especially when liquidity is low. While derivatives can be part of a robust risk management strategy, they have increasingly been used for speculative purposes, leading to significant financial losses if mismanaged.

Derivatives play a crucial role in managing large portfolios and investment funds. Their primary applications include:

• Hedging: Mitigating the impact of adverse price fluctuations (e.g., by selling futures contracts).
• Cash Flow Anticipation: Forecasting future cash flows to inform investment decisions.
• Asset Allocation: Adjusting the distribution of investments across various asset classes.
• Arbitrage: Capitalizing on price discrepancies in different markets.

What is a Futures Contract?

A futures contract is a legally binding agreement between a buyer and a seller regarding the future delivery of an asset.

• Buyer’s Commitment: The buyer agrees to pay a predetermined price for a specified quantity of the asset at a future date.
• Seller’s Commitment: The seller agrees to deliver the asset on that future date in exchange for the agreed-upon amount.

Example

Consider a scenario where a buyer enters into a contract with a seller to pay $56 per barrel for 1,000 barrels of Brent Crude oil, to be delivered in three months. In this case, the buyer—potentially an electricity-generating company—aims to stabilize its fuel costs for oil-fired power stations, while the seller, an oil company, seeks to secure a fixed sales price for its future oil production.

Key Features of Futures Contracts

1. Exchange-Traded: Futures contracts are typically traded on regulated exchanges, such as CME, CBOE or ICE Futures Europe.
2. Standardized Terms: The terms of the contract are standardized by the exchange, which includes specifications for the quality of the underlying asset, the contract quantity, the delivery date, and the delivery location. The only negotiable aspect is the price.

For instance, in the earlier example, the quality of oil is determined by its origin (e.g., Brent Crude from the North Sea), the quantity is fixed at 1,000 barrels, the delivery date is three months in the future, and the delivery location might be the port of Rotterdam.

Futures Terminology

Understanding the terminology used in the derivatives market is crucial:

• Long Position: Refers to the buyer of the futures contract, who commits to purchasing the underlying asset at the agreed price on the specified future date.
• Short Position: Refers to the seller of the futures contract, who commits to delivering the underlying asset in exchange for the agreed price on the specified future date.
• Open Position: The initiation of a trade, which can involve either buying (opening a long position) or selling (opening a short position) a futures contract.
• Underlying Asset: The asset that determines the value of the futures contract.
• Basis: The difference between the cash price of the underlying asset and the futures price.
• Delivery Date: The date on which the transaction is executed, marking the contract's expiration.
• Close: The process of liquidating a position before the contract's expiration.

Most futures contracts are typically closed out before the expiration date, rather than held to delivery.

What is an Option?

An option is a financial derivative that grants the buyer the right, but not the obligation, to buy or sell a specified quantity of an underlying asset at a predetermined exercise price, known as the strike price, on or before a specified future date. In exchange for this right, the seller of the option receives a premium from the buyer.

The term "premium" refers to the cost paid by the buyer (the holder) of the option to the seller (the writer). This premium represents the fee for the rights conferred by the option and is non-refundable. In exchange-traded options, both buyers and sellers transact through an exchange and its clearinghouse, rather than directly with each other.

Types of Options

Options are classified into two main types:

• Call Option: This gives the buyer the right to purchase the underlying asset at the strike price. The seller is obligated to deliver the asset if the buyer chooses to exercise the option.
• Put Option: This grants the buyer the right to sell the underlying asset at the strike price. The seller of the put option is obligated to buy the asset and pay the strike price if the buyer exercises the option.

In options trading, the buyer is referred to as the holder, while the seller is known as the writer. The clearinghouse of the exchange ensures that the rights to buy or sell are honored without the exchange itself taking a position in the underlying asset. The premium is paid upfront by the buyer to the exchange, which then transfers it to the writer.

Examples of Options

Example 1: Suppose you purchase an XYZ plc 850 call option for a premium of $20 when the share price is $800. If the share price rises to $880 at expiration, you would exercise the option and realize a net profit of:

($880 Price at Expiration ?$850 Strike Price)?$20 Premium=$10 Profit

Your return on investment (ROI) would be: $10 (Profit) / $20 (Premium, which is your invested Amount) = 50% Profit Margin

In contrast, had you bought the share outright for $800 and sold it for $880, your ROI would have been:

$80 (Profit) / $800 (Invested Amount) = 10% Profit Margin

Example 2: If shares of Jersey plc are trading at $3.24 and Frank buys a $3.50 call option for three months, he has the right to purchase shares at $3.50 anytime within that period. If the shares rise above $3.50 + $0.42 (the premium), or $3.92, he would make a profit. His maximum loss is limited to the premium paid ($0.42x100shares) = $42. If American Options, they are traded in 100shares per contract. If shares end up at $5 by the expiry (after 3 months), Frank would make $5 (Current Price)-3.50 (strike price)-0.42 (premium) = $1.08x100 = $108 (profit).

Factors Influencing Option Premiums

The option premium is influenced by several factors:

• Underlying Asset Price: Higher asset prices increase the value of call options and decrease the value of put options.
• Exercise Price: Higher exercise prices reduce the value of call options and increase the value of put options.
• Time to Maturity: Longer durations increase the likelihood of the option expiring in-the-money, raising the time value and the premium.
• Volatility: Greater price volatility of the underlying asset enhances the chance of the option expiring in-the-money, leading to a higher premium.

Additional factors include the income yield of the underlying asset and short-term interest rates.

Options Trading Terminology

In the context of American-style options, let’s consider an example involving Example plc. If a call option allows the buyer to purchase shares at $6 while the shares are trading at $6.70, the minimum premium would be $0.70, reflecting the option’s intrinsic value.

In-the-Money

A call option is considered in-the-money when the underlying asset's price exceeds the strike price. For instance, if the market price is $6.70 and the strike price is $6, the option is in-the-money by $0.70.

Out-of-the-Money

An option is classified as out-of-the-money when exercising it would not result in a profit. For call options, this occurs when the market price of the underlying asset is lower than the strike price. For instance, if the shares are trading at $5.50, the call option with a strike price of $6 would be out-of-the-money.

For put options, an option is out-of-the-money when the market price of the underlying asset is higher than the strike price. For example, if a put option has a strike price of $7 while the shares are trading at $7.50, the put option would be out-of-the-money since selling at $7 would yield a loss compared to the market price.

At-the-Money

An option is defined as at-the-money when the strike price is equal to the underlying asset's price which is $6.70. In our example, if the strike price is also $6.70, the option would be at-the-money.

In summary, derivatives, including futures and options, offer versatile strategies for risk management and investment. Understanding their features, types, and terminology is essential for effective trading and portfolio management.