An introduction to derivatives
Contributor: CISI |
A derivative is a financial instrument whose price is based on the price of another asset, known as the underlying asset or simply ‘the underlying’. Their origins can be traced back to agricultural markets, where farmers and merchants would enter into forward contracts that set the price at which a stated amount of a commodity would be delivered.
Today, the underlying asset could be a financial asset such as equities or a commodity such as gold.
Derivatives play a major role in the investment management of many large portfolios and funds. The majority of derivatives take one of three forms: futures, options or swaps.
A future is an agreement between a buyer and a seller. A futures contract is a legally binding obligation between two parties:
- The buyer agrees to pay a prespecified amount for the delivery of a particular prespecified quantity of an asset at a prespecified future date
- The seller agrees to deliver the asset at the future date, in exchange for the prespecified amount of money
A futures contract has two distinct features:
- It is exchange-traded
- It is dealt on standardised terms; the exchange specifies the quality of the underlying asset, the quantity underlying each contract, the future date and the delivery location – only the price is open to negotiation
An option gives a buyer the right, but not the obligation, to buy or sell a specified quantity of an underlying asset at a pre-agreed exercise price, on or before a prespecified future date or between two specified dates. The seller, in exchange for the payment of a premium, grants the option to the buyer.
A key difference between a future and an option is, therefore, that an option gives the right to buy or sell, whereas a future is a legally binding obligation between counterparties.
A swap is an agreement to exchange one set of cash flows for another. They are most commonly used to switch financing from one currency to another or to replace floating interest with fixed interest.
Swaps are a form of over-the-counter (OTC) derivative and are negotiated between the parties to meet the different needs of customers, so each tends to be unique.
Interest rate swaps are the most common form of swaps. They involve an exchange of interest payments and are usually constructed whereby one leg of the swap is a payment of a fixed rate of interest and the other leg is a payment of a floating rate of interest. Interest rate swaps are often used to hedge exposure to interest rate changes.