Derivatives Securit

Derivatives derivative security is a contract that specifies the rights and obligations between the issuer of the security and the holder, to receive or deliver future cash flows (or exchange of other securities or assets) based on some future event. A derivative can have a large number of properties, so that its value depends on many factors. The terms and payments can be derived from the price of a security or commodity, published statistics, an event (such as default on payment), or something else.

Derivatives which are fully standardized like futures and many options are generally traded through a securities exchange or futures exchange. Some derivatives are negotiated privately between parties, and the terms can generally be customized to meet the parties' needs. Standardized contracts traded on an exchange will generally have much greater liquidity.

The payments between the parties may be determined by: the price of some other, independently traded asset in the future (e.g., a common stock); the level of an independently determined index (e.g., a stock index or heating-degree-days); the occurrence of some well-specified event (e.g., a company defaulting); an interest rate; an exchange rate; or some other factor. Some derivatives are the right to buy or sell the underlying security or commodity at some point in the future for a predetermined price.

If the price of the underlying security or commodity moves into the right direction, the owner of the derivative makes money; otherwise, they lose money or the derivative becomes worthless. Depending on the terms of the contract, the potential gain or loss on a derivative can be much higher than if they had traded the underlying security or commodity directly. One use of derivative securities is as a tool to transfer risk. For example, farmers can sell futures contracts on a crop to a speculator before the harvest.

The farmer offloads (or hedges) the risk that the price will rise or fall, and the speculator accepts the risk with the possibility of a large reward. The farmer knows for certain the revenue he will get for the crop that he will grow; the speculator will make a profit if the price rises, but also risks making a loss if the price falls. Of course, speculators may trade with other speculators as well as with hedgers.

In most financial derivatives markets, the value of speculative trading is far higher than the value of true hedge trading. As well as outright speculation, derivatives traders may also look for arbitrage opportunities between different derivatives on identical or closely related underlying securities. Other uses of derivatives are to gain an economic exposure to an underlying security in situations where direct ownership of the underlying security is too costly or is prohibited by legal or regulatory restrictions, or to create a synthetic short position. There are several types of derivatives.

A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time. Therefore, the trade date and delivery date are separated. It is used to control and hedge risk, for example, currency exposure risk (e.g. forward contracts on U.S. dollars or Euros) or commodity prices (e.g. forward contracts on oil). The forward price will usually give a good market estimation of the price in the future.

One party agrees to buy, the other to sell, for a forward price agreed in advance. In a forward transaction, no actual cash changes hands. If the transaction is collaterised, exchange of margin will take place according to an pre-agreed rule or schedule, otherwise no asset of any kind actually changes hands, until the maturity of the contract. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands (on the spot date, usually next business day).

The difference between the spot and the forward price is the forward premium or forward discount. Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in the underlying commodity and are seeking to hedge out the risk of price changes; and speculators, who seek to make a profit by predicting market moves and buying a commodity "on paper" for which they have no practical use. Hedgers typically include producers and consumers of a commodity.

For example, in traditional commodities markets farmers often sell futures for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed. In modern financial markets, "producers" of interest rate swaps or equity derivative products will use financial futures or equity index futures to reduce or remove the risk on the swap.

The utility of futures markets is considered to be mainly in the transfer of risk, and increase liquidity between traders with different risk and time preferences. As an example of how a major corporation uses a forward contract, look at Lufthansa, the German airline, who contracted with Boeing to purchase aircraft in the mid-1980's when the value of the dollar was increasing. The price was set in dollars and Lufthansa was concerned about the dollar strengthening, increasing the Deutsche mark cost of the planes.

In 1986 Lufthansa entered into forward contracts for the dollars required to pay for the planes. Although Lufthansa feared a strenghtening of the dollar, what actually happened is that the dollar weakened. The forward contracts cost Lufthansa $140 to $160 million more for the planes than if it had simply waited and purchased the dollars on the spot market. An option is a contract whereby the contract buyer has a right to exercise a feature of the contract (the option) on or before a future date (the exercise date).

The writer (seller) has the obligation to honor the specified feature of the contract. Since the option gives the buyer a right and the seller an obligation, the buyer has received something of value. The amount the buyer pays the seller for the option is called the option premium. Most often the term "options" refers to a derivative security, an option which gives the holder of the option the right to purchase or sell a security within a predefined time span in the future, for a predetermined amount.

Specific features of options on securities differ by the type of the underlying instrument involved. Real options are another common type. A real option may be something as simple as the opportunity to buy or sell a house at a given price at some period in the future. The writer has the obligation to sell the house to the option buyer for the price agreed in the option while the option buyer does not have to purchase the house at all, so again the buyer has received something of value.

Real options are an increasingly influential tool in corporate finance. One can combine options and other derivatives in a process known as financial engineering to control the risk in a given transaction. The risk taken on can be anywhere from zero to infinite, depending on the combination of derivative features used. Note, by using options, one party transfers (buys or sells) risk to or from another. When using options for insurance, the option holder reduces the risk he bears by paying the option seller a premium to assume it.

Because one can use options to assume risk, one can purchase options to create leverage. The payoff to purchasing an option can be much greater than by purchasing the underlying instrument directly.

For example buying an at-the-money call option for two monetary units per share for a total of 200 units on a security priced at 20 units, will lead to a 100% return on premium if the option is exercised when the underlying security's price has risen by two units, whereas buying the security directly for 20 units per share, would have led to a 10% return. The greater leverage comes at the cost of greater risk of losing 100% of the option premium if the underlying security does not rise in price.

A common use of options for tax planing involves the deferrment of a gain from one period to another, thereby delaying the payment of taxes. For example, one company (company a) may have an investment in another company's stock (company B) that has appreciated. Company a would like to lock in the gain on Company B's stock, but does not wish to recognize the gain in the current year. It can accomplish this by using put options.

This strategy would involve buying put options at the current stock price, expiring in the next fiscal year. If the stock price declines, the value of the option would increase, locking in the profit. Another strategy would be to sell a call option at the current market price. This would also lock in the gain, as any decrease in the price of the stock would be offset the increased value of the option.

These strategies can also be used to reduce the risk of a drop in the stock price without regard to tax issues. In deciding whether to employ these strategies, it is necessary to consider the cost of the option and any related transaction costs. A swap is an agreement in which counterparties (generally two) agree to exchange future cash flows arising from financial instruments. For example, in the case of a generic fixed-to-floating interest rate swap, company a agrees to pay company B.

periodic fixed interest payments on some "notional" principal amount (say $100 million) in exchange for variable rate payments on that notional. The floating "leg" is typically periodically reset based on some reference rate such as LIBOR. Usually, one leg involves quantities that are known in advance (e.g. The "fixed leg" in an interest rate swap) the other involves quantities that are uncertain or variable (e.g. The "floating leg" of an interest rate swap). This is literally true. No one can know with absolute certainty what the 6-month U.S.

dollar LIBOR rate will be in 12 months time or 18 months time. However, if the capital markets do not possess an infallible crystal ball in which the precise trend of future interest rates can be observed, the markets do possess a considerable body of information about the relationship between interest rates and future periods of time. The floating leg must therefore be "reset" against an agreed reference rate, which will become known at some point before the payment or settlement takes place.

For instance the parties might agree to pay 50 basis points (.5%) over the LIBOR measured on the 1st trading day of every 3rd month. The payment schedule is often, but not always, timed to coincide with the resets. The first swaps were commonly used as a way to hedge exposure to market risk for a low fee. For instance, if a trader decides to short sell a stock, there is considerable "market risk" if the stock price rises.

In order to hedge that risk, the trader could enter a swap agreement for the same stock, paying a small fee to "hold" it while not actually having to pay for the stock itself. In this case if the stock price does rise, they simply end the swap and use the stock to pay off the short. In effect, they are buying insurance against their position.

Known as total return swaps, in these contracts all cash flows, dividend payments for instance, are paid or received by the holder as if they owned the stock directly. However, for accounting purposes they are off-balance sheet and do not appear as an asset (they do not legally own the stock in question).

The advantages of interest rate swaps include: a floating-to-fixed swap increases the certainty of an issuer's future obligations; swapping from fixed-to-floating rate may save the issuer money if interest rates decline; swapping allows issuers to revise their debt profile to take advantage of current or expected future market conditions; and interest rate swaps are a financial tool that potentially can help issuers.