Derivatives

The type of investment that allows individuals to buy or sell the option on a security is
called a derivative. Derivatives are types of investments where the investor does not
own the underlying asset, but he or she makes a bet on the direction of the price
movement of the underlying asset via an agreement with another party. There are
many diferent types of derivative instruments, including options, swaps, futures and
forward contracts. Derivatives have numerous uses as well as various risks associated
with them, but are generally considered an alternative way to participate in the
market.
A Quick Review of Terms
Derivatives are difcult to understand partly because they have a unique language.
For instance, many instruments have a counterparty, which is responsible for the
other side of the trade. ach derivative has an underlying asset for which it is basing
its price, risk and basic term structure. The perceived risk of the underlying asset
in!uences the perceived risk of the derivative.
"ricing is also a rather complicated variable. The pricing of the derivative may feature
a strike price, which is the price at which it may be e#ercised. $hen referring to %#ed
income derivatives, there may also be a call price which is the price at which an issuer
can convert a security. Finally, there are diferent positions an investor can take& a
long position means you are the buyer and a short position means you are the seller.
How Derivatives Can Fit into a Portfolio
'nvestors typically use derivatives for three reasons& to hedge a position, to increase
leverage or to speculate on an asset(s movement. )edging a position is usually done
to protect against or insure the risk of an asset. For e#ample if you own shares of a
stock and you want to protect against the chance that the stock(s price will fall, then
you may buy a put option. 'n this case, if the stock price rises you gain because you
own the shares and if the stock price falls, you gain because you own the put option.
The potential loss from holding the security is hedged with the options position.
*everage can be greatly enhanced by using derivatives. Derivatives, speci%cally
options are most valuable in volatile markets. $hen the price of the underlying asset
moves signi%cantly in a favorable direction, then the movement of the option is
magni%ed. +any investors watch the ,'- ./hicago 0oard 1ptions #change ,olatility
'nde#2 which measures the volatility of the 34" 566 'nde# options. )igh volatility
increases the value of both puts and calls. peculating is a technique when investors
bet on the future price of the asset. 0ecause options ofer investors the ability to
leverage their positions, large speculative plays can be e#ecuted at a low cost.
Trading
Derivatives can be bought or sold in two ways. 3ome are traded over7the7counter
.1T/2 while others are traded on an e#change. 1T/ derivatives are contracts that are
made privately between parties such as swap agreements. This market is the larger of
the two markets and is not regulated. Derivatives that trade on an e#change are
standardi8ed contracts. The largest diference between the two markets is that with
1T/ contracts, there is counterparty risk since the contracts are made privately
between the parties and are unregulated, while the e#change derivatives are not
sub9ect to this risk due to the clearing house acting as the intermediary.
Types
There are three basic types of contracts7options, swaps and futures:forward contracts7
with variations of each. 1ptions are contracts that give the right but not the obligation
to buy or sell an asset. 'nvestors typically will use option contracts when they do not
want to risk taking a position in the asset outright, but they want to increase their
e#posure in case of a large movement in the price of the underlying asset. There are
many diferent option trades that an investor can employ, but the most common are&
*ong /all 7 'f you believe a stock(s price will increase, you will buy the right
.long2 to buy .call2 the stock. ;s the long call holder, the payof is positive if the
stock(s price e#ceeds the e#ercise price by more than the premium paid for the
call.
*ong "ut 7 'f you believe a stock(s price will decrease, you will buy the right
.long2 to sell .put2 the stock. ;s the long put holder, the payof is positive if the
stock(s price is below the e#ercise price by more than the premium paid for the
put.
3hort /all 7 'f you believe a stock(s price will decrease, you will sell or write a
call. 'f you sell a call, then the buyer of the call .the long call2 has the control
over whether or not the option will be e#ercised. <ou give up the control as the
short or seller. ;s the writer of the call, the payof is equal to the premium
received by the buyer of the call if the stock(s price declines, but if the stock
rises more than the e#ercise price plus the premium, then the writer will lose
money.
3hort "ut 7 'f you believe the stock(s price will increase, you will sell or write a
put. ;s the writer of the put, the payof is equal to the premium received by the
buyer of the put if the stock price rises, but if the stock price falls below the
e#ercise price minus the premium, then the writer will lose money.
3waps are derivatives where counterparties to e#change cash !ows or other variables
associated with diferent investments. +any times a swap will occur because one
party has a comparative advantage in one area such as borrowing funds under
variable interest rates, while another party can borrow more freely as the %#ed rate. ;
=plain vanilla= swap is a term used for the simplest variation of a swap. There are
many diferent types of swaps, but three common ones are&
'nterest >ate 3waps 7 "arties e#change a %#ed rate for a !oating rate loan. 'f one
party has a %#ed rate loan but has liabilities that are !oating, then that party
may enter into a swap with another party and e#change %#ed rate for a !oating
rate to match liabilities. 'nterest rates swaps can also be entered through option
strategies. ; swaption gives the owner the right but not the obligation .like an
option2 to enter into the swap.
/urrency 3waps 7 1ne party e#changes loan payments and principal in one
currency for payments and principal in another currency.
/ommodity 3waps 7 This type of contract has payments based on the price of
the underlying commodity. 3imilar to a futures contract, a producer can ensure
the price that the commodity will be sold and a consumer can %# the price
which will be paid.
Forward and future contracts are contracts between parties to buy or sell an asset in
the future for a speci%ed price. These contracts are usually written in reference to the
spot or today(s price. The diference between the spot price at time of delivery and
the forward or future price is the pro%t or loss by the purchaser. These contracts are
typically used to hedge risk as well as speculate on future prices. Forwards and
futures contracts difer in a few ways. Futures are standardi8ed contracts that trade on
e#changes whereas forwards are non7standard and trade 1T/.