Macro Mondays: Derivatives

What is a 'Derivative'?

A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, index, or security. Common underlying instruments include: bonds, commodities, currencies, interest rates, market indexes, and stocks.

Futures contracts, forward contracts, options, swaps, and warrants are common derivatives. A futures contract, for example, is a derivative because its value is affected by the performance of the underlying contract. Similarly, a stock option is a derivative because its value is "derived" from that of the underlying stock.

Derivatives are used for speculating and hedging purposes. Speculators seek to profit from changing prices in the underlying asset, index, or security. For example, a trader may attempt to profit from an anticipated drop in an index's price by selling (or going "short") the related futures contract. Derivatives used as a hedge allow the risks associated with the underlying asset's price to be transferred between the parties involved in the contract.

What are the different types of options and contracts and how are they used?

There are three basic types of contracts-options, swaps and futures/forward contracts- with variations of each. Options are contracts that give the right but not the obligation to buy or sell an asset. Investors 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 exposure in case of a large movement in the price of the underlying asset. There are many different option trades that an investor can employ, but the most common are:

• Long Call - If you believe a stock's price will increase, you will buy the right (long) to buy (call) the stock. As the long call holder, the payoff is positive if the stock's price exceeds the exercise price by more than the premium paid for the call.

• Long Put - If you believe a stock's price will decrease, you will buy the right (long) to sell (put) the stock. As the long put holder, the payoff is positive if the stock's price is below the exercise price by more than the premium paid for the put.

• Short Call - If you believe a stock's price will decrease, you will sell or write a call. If you sell a call, then the buyer of the call (the long call) has the control over whether or not the option will be exercised. You give up the control as the short or seller. As the writer of the call, the payoff 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 exercise price plus the premium, then the writer will lose money.

• Short Put - If you believe the stock's price will increase, you will sell or write a put. As the writer of the put, the payoff 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 exercise price minus the premium, then the writer will lose money.

Swaps are derivatives where counterparties to exchange cash flows or other variables associated with different investments. Many 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 fixed rate. A "plain vanilla" swap is a term used for the simplest variation of a swap. There are many different types of swaps, but three common ones are:

• Interest Rate Swaps - Parties exchange a fixed rate for a floating rate loan. If one party has a fixed rate loan but has liabilities that are floating, then that party may enter into a swap with another party and exchange fixed rate for a floating rate to match liabilities. Interest rates swaps can also be entered through option strategies. A swaption gives the owner the right but not the obligation (like an option) to enter into the swap.

• Currency Swaps - One party exchanges loan payments and principal in one currency for payments and principal in another currency.

• Commodity Swaps - This type of contract has payments based on the price of the underlying commodity. Similar to a futures contract, a producer can ensure the price that the commodity will be sold and a consumer can fix 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 specified price. These contracts are usually written in reference to the spot or today's price. The difference between the spot price at time of delivery and the forward or future price is the profit or loss by the purchaser. These contracts are typically used to hedge risk as well as speculate on future prices. Forwards and futures contracts differ in a few ways. Futures are standardized contracts that trade on exchanges whereas forwards are non-standard and trade OTC.