Derivatives

Derivatives are financial instruments whose value changes in response to the changes in underlying variables. The main types of derivatives are futures, forwards, options, and swaps.

The main use of derivatives is to reduce risk for one party. The diverse range of potential underlying assets and pay-off alternatives leads to a huge range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), bonds, interest rates, exchange rates, or indexes (such as a stock market index, consumer price index (CPI) — see inflation derivatives — or even an index of weather conditions, or other derivatives). Their performance can determine both the amount and the timing of the pay-offs.

Types

Due to complexity in nature, it is very difficult to classify the financial derivatives, so in present context, the basic financial derivatives which are popular in the market have been described in brief.

One form of classification of derivative instruments is between commodity derivatives and financial derivatives. The basic difference between these is in the nature of the underlying asset or instrument. In commodity derivatives, the underlying instrument is a commodity which may be wheat, cotton, pepper, sugar, jute, corn, gold, silver and so on. In a financial derivative, the underlying instrument may be treasury bills, stocks, bonds, foreign exchange, stock index, cost of living index etc. It is to be noted that financial derivative is fairly standard and there is no quality issues whereas in commodity derivative, the quality may be the underlying matters. However, the distinction between these two from structure and functioning point of view, both are almost similar in nature.

Another way of classifying the financial derivatives are is into basic and complex derivatives. In this, forward contracts, futures, contracts and options contracts have been included in the basic derivatives. Whereas swaps and other complex derivatives are taken into complex category because they are built up from either forwards/futures or options contracts, or both, such derivatives are effectively derivatives of derivatives.

Options and futures

Futures and options represent two of the most common form of "Derivatives". Derivatives are financial instruments that derive their value from an 'underlying'. The underlying can be a stock issued by a company, a currency, Gold etc., The derivative instrument can be traded independently of the underlying asset. The value of the derivative instrument changes according to the changes in the value of the underlying. Derivatives are of two types -- exchange traded and over the counter.
Exchange traded derivatives, as the name signifies are traded through organized exchanges around the world. These instruments can be bought and sold through these exchanges, just like the stock market. Some of the common exchange traded derivative instruments are futures and options.
Over the counter (popularly known as OTC) derivatives are not traded through the exchanges. They are not standardized and have varied features. Some of the popular OTC instruments are forwards, swaps, swaptions etc.
Futures A 'Future' is a contract to buy or sell the underlying asset for a specific price at a pre-determined time. If you buy a futures contract, it means that you promise to pay the price of the asset at a specified time. If you sell a future, you effectively make a promise to transfer the asset to the buyer of the future at a specified price at a particular time. Every futures contract has the following features:

• Buyer
• Seller
• Price
• Expiry

Some of the most popular assets on which futures contracts are available are equity stocks, indices, commodities and currency.

The difference between the price of the underlying asset in the spot market and the futures market is called 'Basis'. (As 'spot market' is a market for immediate delivery) The basis is usually negative, which means that the price of the asset in the futures market is more than the price in the spot market. This is because of the interest cost, storage cost, insurance premium etc., That is, if you buy the asset in the spot market, you will be incurring all these expenses, which are not needed if you buy a futures contract. This condition of basis being negative is called as 'Contango'.
Sometimes it is more profitable to hold the asset in physical form than in the form of futures. For eg: if you hold equity shares in your account you will receive dividends, whereas if you hold equity futures you will not be eligible for any dividend.

When these benefits overshadow the expenses associated with the holding of the asset, the basis becomes positive (i.e., the price of the asset in the spot market is more than in the futures market). This condition is called 'Backwardation'. Backwardation generally happens if the price of the asset is expected to fall.
It is common that, as the futures contract approaches maturity, the futures price and the spot price tend to close in the gap between them ie., the basis slowly becomes zero.

Options
Options contracts are instruments that give the holder of the instrument the right to buy or sell the underlying asset at a predetermined price. An option can be a 'call' option or a 'put' option.

A call option gives the buyer, the right to buy the asset at a given price. This 'given price' is called 'strike price'. It should be noted that while the holder of the call option has a right to demand sale of asset from the seller, the seller has only the obligation and not the right. For eg: if the buyer wants to buy the asset, the seller has to sell it. He does not have a right.

Similarly a 'put' option gives the buyer a right to sell the asset at the 'strike price' to the buyer. Here the buyer has the right to sell and the seller has the obligation to buy.

So in any options contract, the right to exercise the option is vested with the buyer of the contract. The seller of the contract has only the obligation and no right. As the seller of the contract bears the obligation, he is paid a price called as 'premium'. Therefore the price that is paid for buying an option contract is called as premium.
The buyer of a call option will not exercise his option (to buy) if, on expiry, the price of the asset in the spot market is less than the strike price of the call. For eg: A bought a call at a strike price of Rs 500. On expiry the price of the asset is Rs 450. A will not exercise his call. Because he can buy the same asset from the market at Rs 450, rather than paying Rs 500 to the seller of the option.

The buyer of a put option will not exercise his option (to sell) if, on expiry, the price of the asset in the spot market is more than the strike price of the call. For eg: B bought a put at a strike price of Rs 600. On expiry the price of the asset is Rs 619. A will not exercise his put option. Because he can sell the same asset in the market at Rs 619, rather than giving it to the seller of the put option for Rs 600.

Option pricing

Main Components of an Options Premium

The premium of an option has two main components: intrinsic value and time value.

Intrinsic Value (Calls):

When the underlying security's price is higher than the strike price a call option is said to be "in-the-money."

Intrinsic Value (Puts):

If the underlying security's price is less than the strike price, a put option is "in-the-money." Only in-the-money options have intrinsic value, representing the difference between the current price of the underlying security and the option's exercise price, or strike price.

Time Value:

Prior to expiration, any premium in excess of intrinsic value is called time value. Time value is also known as the amount an investor is willing to pay for an option above its intrinsic value, in the hope that at some time prior to expiration its value will increase because of a favorable change in the price of the underlying security. The longer the amount of time for market conditions to work to an investor's benefit, the greater the time value.

Six Major Factors Influencing Options Premium

There are six major factors that influence option premiums. The factors having the greatest effect are:

• A change in price of the underlying security
• Strike price
• Time until expiration
• Volatility of the underlying security
• Dividends/Risk-free interest rate

Dividends and risk-free interest rate have a lesser effect.

Changes in the underlying security price can increase or decrease the value of an option. These price changes have opposite effects on calls and puts. For instance, as the value of the underlying security rises, a call will generally increase and the value of a put will generally decrease in price. A decrease in the underlying security's value will generally have the opposite effect.

The strike price determines whether or not an option has any intrinsic value. An option's premium (intrinsic value plus time value) generally increases as the option becomes further in the money, and decreases as the option becomes more deeply out of the money.

Time until expiration, as discussed above, affects the time value component of an option's premium. Generally, as expiration approaches, the levels of an option's time value, for both puts and calls, decreases or "erodes." This effect is most noticeable with at-the-money options.

The effect of volatility is the most subjective and perhaps the most difficult factor to quantify, but it can have a significant impact on the time value portion of an option's premium. Volatility is simply a measure of risk (uncertainty), or variability of price of an option's underlying security. Higher volatility estimates reflect greater expected fluctuations (in either direction) in underlying price levels. This expectation generally results in higher option premiums for puts and calls alike, and is most noticeable with at-the-money options.

The effect of an underlying security's dividends and the current risk-free interest rate have a small but measurable effect on option premiums. This effect reflects the "cost of carry" of shares in an underlying security -- the interest that might be paid for margin or received from alternative investments (such as a Treasury bill), and the dividends that would be received by owning shares outright.