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What Are Derivatives?

What Are Derivatives?

Have you heard of the word derivative, but don’t know what it means? Kevin Morgan, from OMF, explains.

7 October 2021

Derivatives are another way to trade the financial markets. They’re a contract between two or more parties. Their value is ‘derived’ from an underlying asset.

That asset could be shares, currencies, commodities like wool or oil, bonds or anything else that can be traded on an exchange.

Derivatives are traded either on an exchange or over the counter (OTC) which means informally traded between two counterparties. These counterparties can be banks, brokers, or corporates.

Two common derivatives ‘instruments’ are futures and options.

What is a future?

A futures contract is a legally binding agreement made between two parties to buy or sell a commodity or financial instrument at an agreed price, on a specified date in the future.

Details like the quantity and quality of the underlying commodity are specified, for example: a standard gold futures contract traded on the Chicago Mercantile Exchange is for 100 troy ounces of gold, with details of its composition listed.

To enter a futures position, both the buyer and the seller must deposit a performance bond (called a margin) with the exchange.

What is an option?

An option contract gives the buyer the right, but not the obligation, to buy (‘call’ option) or sell (‘put’ option) the underlying asset at an agreed price until a specific date.

Unlike futures contracts, the holder does not have to buy or sell the underlying asset if they choose not to. To own an option, you must pay a cash amount, known as a premium.

Options all have an expiry date. At expiry, the holder of the option will decide if they wish to buy or sell the underlying commodity. If they decide not to, they’ll simply let the option expire.

The other side of this is that the seller, or writer, of an option receives the cash amount (premium) but he now has the obligation, but not the right, to buy or sell the underlying asset.

Who uses derivatives?

The main types of users of derivatives are:

Hedgers: They’re looking to protect from or eliminate an underlying business risk. They could be fund managers looking to offset a decline in share prices; importers or exporters protecting their business against unfavourable currency moves; farmers wanting to lock in a firm milk price; or borrowers protecting themselves against a hike in interest rates.

Speculators: They want to profit from changing prices in the underlying asset. They could be a currency trader who thinks the value of the New Zealand dollar will fall against the US dollar; or a trader who thinks that the price of gold will go up.

Investors that own a portfolio of shares: They can enhance their returns by selling call options over some of the shares they own. This is known as selling ‘covered’ calls.

Hedging with futures

Here’s an example of how you might hedge with futures:

A fund manager has a global equity portfolio of US$100 million. He’s worried markets could fall soon. He wants to protect his portfolio without selling any shares.

He sells futures on the Standard and Poor’s 500 Index (S&P 500) to the value of US$100 million, which is about 650 contracts. The current level of the index is 3,000.

Over the next few weeks, the market falls around 10 per cent, to 2,700. The fund manager now thinks that the sell-off is over, so he buys back the 650 futures contracts at 2,700.

This results in a cash profit of US$9.75 million, which offsets the assumed 10 per cent loss of value in his portfolio.

Hedging with options

Here’s how you might hedge with options:

A New Zealand importer buys stock in US dollars from China. His costs will rise if the NZD/USD exchange rate falls.

Over the next three months, he’ll be buying around US$5 million of stock from his supplier. The NZD/USD rate is currently 0.6400.

At the current exchange rate, his profit margin would be 10 per cent, or US$500,000. He wants to lock this in. He decides to buy an option to purchase US$5 million at 0.6400 that expires in three months. The premium (cost) is US$50,000.

Scenario 1. The NZD/USD falls to 0.6200. The importer exercises his right to sell NZD and buy US$5 million at 0.6400.

Scenario 2. The NZD/USD rises to 0.6600. The importer lets the option expire and buys the US$5 million at 0.6600, substantially reducing the amount of NZ dollars he needs.

The key element here is that the importer is not obliged to deal at 0.6400 and so, he can buy the US dollars at a better rate if it becomes available. The price for this flexibility is the premium he paid.

Speculating with futures

Here’s how you might speculate with futures:

A trader thinks that the price of gold will rise from its current level of US$1,500 an ounce, to US$1,600 an ounce.

He buys one 100-ounce gold future. The contract has an underlying value of US$150,000, however he only has to put down a margin deposit of US$5,500. For each one US dollar move in the price of gold, the trader will make or lose US$100.

The trader will also need to have enough funds in his brokerage account to cover any unrealised losses.

If the client has less than this, he’ll receive a margin call from his broker requesting additional funds.

If the trader is correct and the market moves to US$1,600 an ounce, he will sell his contract and bank US$10,000 profit. If he closes the position below US$1,500, he’ll take a loss. Once the position is closed, the margin deposit is returned.

Futures and options are sophisticated financial products and investors should always contact a reputable derivative broker before entering into any trading positions.

Published 15 November 2019

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