What is a Derivative Security?
A Derivative Security is a financial instrument whose value depends on the underlying asset.
Examples of Derivative Securities are:
Examples of Underlying Assets are:
- Financial Securities
- Stock indices
- Metals (copper, gold, silver)
- Agricultural (corn, cotton, orange juice, coffee, cattle)
- Oil products, natural gas
A Futures Contract is an agreement between a buyer (long position) and a seller (short position), to buy or sell the underlying asset at a certain time in the future (which is the maturity date), with a predetermined price. But most futures contracts are closed out before the maturity date (by taking offsetting position), which results in a profit or loss.
For example, in August, a jewellery manufacturer, who needs gold in September enters into a long futures contract (long position = trader will buy the asset at maturity), which expires in October. The manufacturer has entered into a long futures contract to hedge the risk of increase in gold price. Suppose, in August, the market price of gold is trading at $1,500 per ounce and October gold futures are trading at $1,600 per ounce. In August, the manufacturer enters into long gold futures contract at $1,600.
In September, the sport market gold price is trading at $1,600 and futures expiring on October is trading at $1,700. The jewellery manufacturer now needs gold for production. The manufacturer purchases gold at the market price of $1,600. Then, closes out futures position by taking opposing position in the futures market (in order for this trader to close out the position, short futures positionis necessary).
Futures Example Summarised:
|In August: Jewellery manufacturer needs gold for use in SeptemberHedges the risk of increase in price by entering into October futures position = $1,600Now benefits if there is an increase in gold price||In September: Jewellery manufacturer buys gold needed at the market price = $1,600 Closes the futures position by entering a short October futures position = $1,700|
|The final cash settlement for the transactions are: Market price in September -(Short Futures in September-Long Futures in August)=The price which will be paid
$1600-($1700-$1600)=$1500 (price paid)<$1600 (market value .
Thus, the Jewellery Manufacturer have profited from the increase in market price, paying $100 less than the market value of gold.
Forward Contracts are very similar to Futures Contracts. A forward contract is also an agreement between buyer and a seller to buy or sell the underlying asset at a certain time in the future, with a predetermined price. However, one of the main differences is that forward contracts cannot be closed out before the maturity date.
An Options Contract gives the buyer (long position) of the contract an option to buy or sell the underlying asset at a strike price.
- The buyer (long) of the options contract pays a premium for the right
- The buyer has an opportunity to earn unlimited profit with limited risk (the risk here is the premium that was paid)
- The writer (short) of the option contract receives a premium from the buyer
- The writer has an opportunity to earn premium income but has an obligation to meet the right when option is exercised, and risk is unlimited.
There is a total of four different options position you can take:
- Long call: The buyer of a call option has an option to buy the underlying asset, at maturity, at a predetermined price
- Short call: The writer of a call option is obligated to sell the underlying asset, at maturity, if the option is exercised, at a predetermined price
- Long Put: The buyer of a put option has an option to sell the underlying asset, at maturity, at a predetermined price
- Short Put: The writer of a put option is obligated to buy the underlying asset, at maturity, if the option is exercised, at a predetermined price
Swap Contracts are used to swap liabilities between different parties
- For example, interest rate swap can be used to convert fixed to floating interest rate and vice versa
- Assume a swap contract between Party A and Party B. Party A has entered a loan with a bank on a fixed interest rate contract. Party B has entered into a loan with floating interest rate. However, Party A wishes to make their loan repayments using floating rate vice versa for Party B. Therefore, Party A and Party B agrees to enter into a swap contract and both parties are now able to make payments on their desired rates.
- Swaps Example Summarised:
- Currency swap can convert a liability from one currency to another.
The Participants in Derivative Market:
- Provides protection against adverse price changes
- Enables investors to take a position in the market by betting on future price movements
- Takes on risk to generate profit
- Aims to make risk-free profit by taking advantage of market inefficiencies
Pros and Cons:
Derivative securities are financial instrument which enables traders to hedge their risk arising from random price movements in the market. They are used by many companies (often commodity related) to lower their risk, as it promises delivery of raw material at an agreed price.
However, derivative securities also have its drawbacks. It is difficult to calculate its value as they are based upon price of another asset. Also, there is a risk that the counterparty may default, and derivatives are often leveraged, meaning the return is higher when profited, but losses are also greater.
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The information above should not be taken as financial advice. Youth Investment Group has no liability for personal financial interests or investment decisions. You should make your own investment decisions based upon your own research and what you believe is best for you.
Written by associate Jaewon Jung