WHAT IS A DERIVATIVE?

“Too much of a good thing can be wonderful” ~ Mae West

One can easily be overwhelmed by the apparently countless types of derivative instruments traded in the market place. Do not be misled however; derivatives are not nearly as mystifying as they may seem.  Derivatives are “Instruments” that derive their value from an underlying price, index, etc.

An asset is an item of ownership having positive monetary value. A liability is an item of ownership having negative monetary value. The term “instrument” is used to describe a “CONTRACT” that gives rise to assets and liabilities. Contract is more general term which is an agreement between two or more parties for an economic consideration enforceable by law.

A derivative contract usually has a notional face value or reference amount which is the ‘volume’ of the contract. Applying the volume to a change in the underlying price determines the amount to be exchanged at the settlement date.

Fundamentally, there are only two types of derivative contracts – a forward contract and an option contract.  Hence the derivative market is F&O (Futures & Options)

A forward is a contract to buy or sell an underlying asset at some pre-specified future date at a price agreed upon today. No money changes hands until the expiration date, at which time the buyer pays the cash and the seller delivers the underlying asset.

One would wonder then what are futures? Futures are exchange-traded Forward contracts. 

Swaps tantamount to exchange of cash flows between two parties. So is swap too a forward? Yes true!! Swaps branch from a family of forwards. They are single contract encompassing mini forward contracts or a collection of small forward contracts in a single contract.

An option is a contract to buy or sell an underlying at some pre-specified date at a price agreed today. Unlike a forward however, the buyer has the right but not an obligation to buy or sell an underlying at the option expiration. The seller’s obligation depends upon whether or not the buyer chooses to exercise the option.  

Derivatives and Your Career

The primary use of derivatives is in risk management. Businesses, by their very nature, face risks. Some of those risks are acceptable; indeed a business must assume some type of risk or there is no reason to be in business. But other types of risk are unacceptable and should be managed.

Take an example; a small handicraft manufacturing unit borrows money from a bank at floating interest rate to reflect current interest rates in the market. The handicraft manufacturer is in the business of making money off the handicraft sales. It is not particularly suited to forecast interest rate movements. Yet interest rate increases could severely hamper its ability to make a profit from its business. If it sells its products in foreign countries, it may face significant foreign exchange volatility risk. Risks have the potential to undermine the success of main line of business.

It was but a few years back that a small firm would not be expected to use derivatives to manage its interest rate or foreign exchange risk, nor would it be able to do so if it wanted. The minimum sizes of transactions then were too large. Times have changed and smaller firms are now more able to use derivatives.

If your career takes you in investment management, you will surely encounter derivatives. Those in public sectors like LIC, etc find numerous applications of derivatives. Those responsible for commodities and green concept (carbon emission) will encounter situations where derivatives are or can be used. In short, derivatives are becoming commonplace and are likely to be more so for the foreseeable future.

Derivatives lie at the very heart of every business!!