Explain it to me like I am a 5-year-old: Derivatives (Futures, Forwards, Swaps, Options)

I am a graduate student pursuing Masters in Computer Science from NYU wanting to understand finance and many of the underlying concepts. This post is meant for people who are completely new to Finance but want to have a basic understanding of the stock market. My aim here is to make the concepts easier and more understandable.

What do you mean by Derivative?

It’s financial contract whose price depends on the underlying asset or a group of assets. The underlying asset can be stocks, bonds, commodities, currencies, interest rate etc.

They are traded either on the exchange(link to financial market page) or over-the-counter (OTC). Derivatives were first brought into the market to balance the exchange rate of goods traded internationally. Because of the volatility of currencies and difference in their values, international traders wanted to have a system to account these differences. Nowadays there are derivatives based on weather data like the amount of rain etc.

For example, if you are in the United States but want to invest in an Indian company by buying shares from the Indian Stock Exchange in Indian Rupees.

Here you are prone to exchange rate risk meaning let’s suppose you want to sell the Indian stock and reap the profits and meanwhile the US Dollar rate increases with respect to Indian Rupees. Now the profit that you get after selling the Indian Stock will be in Indian Rupees and when you try to convert it to US Dollars it will be less as the price of US Dollar has increased.

Let’s say while buying the Indian Stock, the exchange rate was $1 equals 70 INR. By the time you want to sell the stock, the dollar becomes more expensive say now $1 equals 100 INR and now if you get a profit of 75INR implies that you get a profit of $0.75 (75/100) because US Dollar is now more valuable. Had you locked down the exchange rate of $1 implies 70INR, your profit would have been $1.07 (75/70) and not $0.75. This locked down can take place by buying currency derivative.

Some common forms of Derivatives:

Futures:

It’s an agreement between parties to buy or sell an asset at a certain time in the future and at a certain price. Let’s say there is a Christmas sale on Xbox where it’s been sold for $300 instead of $600 and you want to buy the Xbox, the only problem being: you don’t have enough money to buy it right now but you don’t want to miss out of this opportunity. If there is a way that you can buy the Xbox at the same discounted rate even after a few months then it would be great. This contract of getting the Xbox at the discounted price after a few months is called Futures Contract. As you can see here the price is dependent on the underlying asset (Xbox) hence it’s a form of derivative.

Each futures contract has got a specific lot size. You cannot buy a futures contract involving 1 share of company ABC. If ABC’s lot size is 100 that means 1 futures contract of company ABC is equivalent of buying 100 shares of ABC. The best thing is, you don’t have to pay the price of all the shares. Let’s say each share of company ABC costs $10 and you buy 1 lot of ABC which means 100 shares of ABC; so instead of paying $1000 (10 x 100) for 1 lot, you pay something called the margin of the contract. If the margin is 10% then you pay $100(10% of $1000) for 1 lot instead of $1000. So by paying $100, you are now in charge of 100 shares of ABC instead of paying $1000 (10 x 100). If the price of ABC’s share now increases from $10 to $15, you get a profit of $500 ((15–10) x 100) on the margin amount you had paid i.e. 500% return. If you had bought the shares for $1000 instead of the futures contract, you still would have got $500 profit, but in term is %return it would have been 50%

Let’s say there is a future’s contract between you and the oil company and the agreed price is $10/barrel and the lot size is 200 barrels. For example, say the futures contracts for oil increases to $15/barrel the day after you and the oil company enters into the futures contract at $10/barrel. The oil company has lost $5/barrel because the selling price just increased from the price at which they were obligated to sell the oil. You are profited by $5/barrel because the price you are obligated to pay is less than what the rest of the market is obliged to pay in the future for oil. So on that day, $1,000 ((15–10) x 200) is debited from the oil company’s account and $1,000 is credited to your account. These kinds of adjustments are done every day, as the market moves, depending on the closing price of oil each day.

Unlike the stock market, futures positions are settled on a daily basis, which means that gains and losses from the day’s trading are deducted or credited to your account each day at the end of the trading session. In the stock market, the gains or losses from movements in price aren’t realised until you sell the stock. When either party decides to close out their futures position, the contract will be settled. If the contract was settled at $15/barrel, the oil company would lose $1,000 on the futures contract and you would have made $1,000 on the contract.

Forwards:

Forwards are similar to Futures with the only difference being that they are not traded on an exchange but are traded on over-the-counter markets. So as there is no central exchange to keep track of what goes where and the terms aren’t regularised, you can change the lot size and the settlement process for the derivative. It also involves counterparty risk which means that it is possible that either the buyer or the seller in the contract is not able to meet financial needs or basically doesn’t have money to pay back. This happens because it is not under any regulations and sometimes buyer or seller sells the contract to some other party because of which more people get involved.Consider you and the oil company have the contract so now it is possible that the oil company will sell the contract to some other company ABC. Which means that now you and ABC have a contract which increases the counterparty risk.

Swap:

Swap is literally what the word means. Let’s say there are two businessmen Karan and Bhoomit. They both have 5 Playstation’s and 5 Xbox’s. But Karan wants to make business in Playstations and Bhoomit wants to make business in Xbox’s. Assume that they cannot trade directly with each other. So they go to a SWAP Bank let’s say HSBC. HSBC tells Karan to give all his Xbox’s, it then keeps one with itself and gives the rest 4 Xbox’s to Bhoomit while HSBC asks Bhoomit to give all his Playstations, keeps one to itself and gives rest 4 Playstations to Karan. Now Karan has 9 Playstations and Bhoomit has 9 Xbox’s and HSBC has 1 Xbox and 1 PlayStation. So HSBC gets some profit to initiate the swap.

In more real terms, let’s say Karan is in India and Bhoomit is in Australia. Karan goes to a bank in India asking for a loan for his business and the bank says we offer 1. Fixed Rate of 6% and 2. Floating rate of LIBOR+3%.Bhoomit goes to a bank in Australia asking for a loan for his business and the bank says we offer 1. Fixed Rate of 8% and 2. Floating rate of LIBOR+1%.

Karan has the requirement of Floating Rate and Bhoomit has the requirement of Fixed Rate. So HSBC tells Karan to buy Fixed Rate, in return, he will get a Floating rate of LIBOR+2% and HSBC tells Bhoomit to buy Floating rate, in return he will get a Fixed rate of 7%. So here what HSBC does is called swapping, it swaps the Floating rate from Australia to India and Fixed Rate from India to Australia.

Swaps related to the cash flows and potential defaults of mortgage bonds are an extremely popular kind of derivative.

Options:

To know about what options are and how they work, have a look at my Medium Post.

Please do let me know if there is any other concept in finance you want me to write an article on, I will try my best to explain it in simpler terms.

Also, feel free to ask questions in the comment section. Will be happy to help you out :)

PS: The analogy I have used might not be 100% correct but it’s easy to understand things with a simpler analogy.

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