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A derivative is a contract whose value comes from the value of something else at a future date.
That something else is the underlying. It can be an asset, such as a share, a bond or a commodity, or a variable, such as an interest rate or an index level.
When the underlying moves, the derivative's value moves with it.
Take a forward contract: today, two parties agree that one will buy 100 shares of Indus Ltd from the other at USD 50 a share in 3 months.
At settlement, the buyer pays 100 × 50 = USD 5,000 for the shares.
The forward price is set so the contract has zero value to both parties at initiation.
So no money changes hands when the contract is agreed. Neither side is expected to come out ahead at the start.
Value appears only later, as the share price moves away from USD 50.
At settlement, compare the share's spot price (its market price then) with the forward price of USD 50. Move the spot price:
At 58, the buyer pays 5,000 for shares worth 5,800: a gain of 800. The seller loses exactly 800.
The buyer of the forward gains when the underlying's price rises, just like owning it. The buyer has long exposure to the underlying.
The seller gains when the price falls. The seller has short exposure.
At settlement, one party's gain equals the other party's loss.
Check yourself
A contract says how it ends. Toggle the two methods for a spot price of USD 44:
The shares and the full payment change hands at settlement.
Suppose the seller already owns 100 Indus shares and fears a fall. Selling the forward locks in USD 5,000 whatever the price does. Her share price risk has moved to the buyer.
Offsetting a risk you already have is hedging. If the derivative matches the risk exactly, it's a full hedge. If it offsets only part of the risk, it's a partial hedge.
Now suppose the buyer owns no Indus shares and has no other exposure to them.
Buying the forward doesn't offset anything. It adds risk. Taking on a risk you didn't have, to profit from a view on the price, is speculating.
The same contract can be a hedge for one party and speculation for the other.
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The shareholder could also remove her risk with a cash market trade: selling the shares today. Derivatives can be better because:
Higher interest rates mean lower bond prices.
A rule for hedgers: do in the futures market what you must do in the future. A baker who must buy wheat later buys wheat forwards. A farmer who must sell wheat later sells them.
Futures and some options trade on an exchange. The largest by number of trades include the National Stock Exchange of India, B3 (Brazil) and CME Group (US).
A central clearinghouse takes the opposite side of each party's trade, a process called novation. It guarantees the promised payments.
To back that guarantee, it requires deposits (margin) from both parties at initiation, plus more from any account that falls in value.
Forwards, most swaps and some options are created by dealers in a market with no central location: the OTC market.
After the 2008 financial crisis, regulators required many swaps to be centrally cleared.
A dealer records the trade on a swap execution facility (SEF). A central counterparty (CCP) then replaces it with two trades, one with each side, so the CCP faces both parties.
Counterparty risk falls and disclosure rises, but the contracts stay customizable. The downside: risk is concentrated in the CCP instead of spread across dealers.
Exit a position by entering the opposite contract.
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Check yourself
| Exchange-traded | OTC | |
|---|---|---|
| Terms | Standardized | Customized |
| Counterparty | Clearinghouse | Dealer |
| Margin | Yes | Not if uncleared |
A forward's price is set so its value is zero at initiation. The buyer has long exposure; the seller has short exposure.
That's the reading.
Now test it on exam-style questions while it's fresh.