Defining Derivative and the Basic Features of a Derivative Instrument

What is a Derivative?

A derivative is a financial instrument that derives (obtains) its value from the performance of an underlying. The underlying may be a single asset, a group of assets, or variables such as interest rates.

Creation of Derivatives

A derivative is created in the form of a derivative contract involving two counterparties: a buyer and a seller. A derivative contract is a legal agreement between counterparties that defines the rights and obligations of each party. It contains specific maturity or settlement.

The buyer is the long or the holder, owns the derivative, and is said to hold a long position. On the other hand, the seller is referred to as short and holds a short position.

Derivatives can be stand-alone or embedded. Stand-alone derivatives are distinct. An example, a is a derivative on a bond. On the other hand, embedded derivatives are derivatives within an underlying, for example, callable, puttable, and convertible bonds.

Derivatives can be classified into either one of two categories:

1. Firm Commitment (Forward Commitment)

In firm commitment, an amount is pre-determined, and the parties involved make an agreement to exchange it at a future date. Firm commitments include forward contracts, futures contracts, and swaps.

2. Contingent Claim

In a contingent claim, the settlement of the trade depends on one of the counterparties. Options are the primary contingent claims.

Benefits of Using Derivatives

Investors can get access to broad opportunities by creating or modifying exposures in the following  ways:

1. Earning profits by short selling an underlying whose value is expected to decline.
2. Diversifying a portfolio.
3. Offsetting the financial market exposure that comes with a commercial transaction.
4. Creating large exposures to an underlying using relatively low amounts of cash.
5. Either increasing or decreasing financial market exposure. For instance, hedging uses derivatives to offset (neutralize) existing (anticipated) exposure to an underlying.

Uses of Derivatives

1. Hedging: Reduce or eliminate certain forms of risk.
2. Speculation: Derivatives have, as an inherent feature, a high degree of leverage. This means that investors only commit small amounts of money to a derivative position relative to the equivalent position in the underlying asset. Small movements in the underlying can lead to large movements in the derivative – both positive and negative.
3. Arbitrage: Simultaneous buying and selling to take advantage of varying prices for the same asset to earn a riskless profit.

Note: Unlike the spot markets, derivative markets have lower transaction costs and are more liquid.

Derivative Underlyings

One way of classifying a derivative is by using the underlying from which the derivative derives its value.

Commonly used underlyings are equities, fixed income, interest rates, currencies, commodities, and credit.

Equities

Derivatives that use equities as the underlying may reference a single stock, a group of stocks, or a stock index. Options are predominantly associated with individual stocks, while index derivatives are mostly traded as options, futures, forwards, and swaps.

In index or equity swaps, an investor can receive a return on one index or interest rate and pay the return on one stock index. Investment managers can also use index swaps to increase or decrease exposure to an equity market without trading in individual shares.

Investors trade options on individual stocks. Also, issuers may use stock options to compensate their executives and employees as a motivation for greater corporate performance, which leads to higher stock prices.

Besides, companies may issue warrants. Warrants are stock options that give their holders the right to purchase shares at a fixed price directly from the issuer in the future.

Fixed-Income Instruments and Interest Rates

Fixed income instruments mostly use bonds as the underlying. Associated derivatives include futures, swaps, and options.

Interest rate is a fixed income underlying used by interest rate derivatives, such as forwards, futures, and options. Note that interest rate is not considered an asset. Interest rate swaps are usually used to convert from a fixed interest rate to a floating interest rate exposure – or vice versa – over a certain period. Interest rate swaps mostly use a market reference rate (MRR) as the underlying. The most common market reference rate is the secured overnight financing rate (SOFR).

Currencies

Derivatives can be used to hedge foreign exchange risk in commercial and financial transactions. For example, exporters may use forward contracts to sell domestic currency and buy foreign currency in a way that coincides with the delivery of goods or services in a foreign country.

Commodities

Commodities are classified into hard or soft commodities. Hard commodities are natural resources such as crude oil. Soft commodities, on the other hand, are agricultural products such as crops and cattle.

Derivatives on commodities are usually used to manage the price risk of an individual commodity or a commodity index separate from physical delivery.

Credit

Derivative contracts that use credit as an underlying are based on the default risk of either a single or a group of issuers. For instance, Credit Default Swaps (CDS) help manage the risk of loss if a borrower defaults.

Others

Others include weather, cryptocurrencies, and longevity. Derivatives that use such underlyings are less common, and their pricing is challenging.

Question

Which of the following derivatives most likely represents a contingent claim?

A. Futures.

B. Options.

C. Forwards.

The correct answer is B.

Options are the primary contingent claims. For a contingent claim, trade occurrence depends on one of the counterparties.

A and C are incorrect. For firm commitments, an amount is pre-determined and an agreement is made to exchange it at a future date. Forward or firm commitments include forwards swaps, and futures.