Finance – Derivatives

Finance – Derivatives

A derivative contract is a contractual agreement to execute an exchange at some future date. The term “derivative” arises from the fact that the agreement “derives” its value from the price of an underlying asset such as stock, bond, currency or commodity. A stock index futures derives its value from an underlying exchange rate and so on. The key feature of the transaction specified in a derivative contract is that it will be executed in the future rather than today.

One can easily become overwhelmed by the apparently countless types of derivative contracts traded in the market place. The pages of the Wall Street Journal list the prices of tens of thousands of standardized, exchange-traded futures, options and futures option contracts on hundreds of different underlying assets. And this only begins to scratch the surface. The WSJ reports only trading summaries for US derivatives exchanges. Other exchanges worldwide have derivatives trading volume roughly equal to that in the United States. Moreover, the notional amount of exchange-traded derivatives worldwide represents only about 16% of all derivatives outstanding (i.e., USD 233.9 trillion as of December 2003). About 84% of derivatives are private contracts arranged with banks and various other financial houses. Many of these contracts are plain-vanilla forwards, swaps, caps, collars, or floors, but one can hear of inverse floaters, protected equity notes, ratio swaps, time swaps, knockout options, spread locks, wedding-band swaps and the like.

Fundamentally there are two types of contracts – a forward and an option. A forward is a contract to buy or sell an underlying asset at some specified future date at a price agreed upon today. No money changes hands until the expiration date, at which time the buyer pays the amount of cash specified in the contract and the seller delivers the underlying asset.

An option is also a contract to buy or sell an underlying asset at some prespecified future date at a price agreed upon today. Unlike a forward, however, the buyer of the option has the right but not the obligation to buy or sell the asset. The right to buy the underlying asset at a specified price on or before some specified future date is called a call option. The right to sell the underlying asset is called a put option. The amount that the option buyer pays the seller for the right is called the option premium.

A future contract is virtually identical to a forward contract. The only difference is that the gains and/or losses on a futures position are posted each day.

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