A derivative is a financial instrument that provides a return that depends on the price of another underlying asset.
A derivative has a finite life and usually the payoff or return on the derivative is decided on the expiry date.
Exchange-traded versus over-the-counter derivatives
Exchange-traded derivatives have standard terms and are traded in an organized derivatives market or exchange. Over-the-counter derivatives are ones which are traded between two parties outside the exchange.
Derivatives are either forward contracts or contingent claims. Forward contracts or commitments are ones where two parties agree to do a transaction at a later date at a price decided in the starting.
We will look at exchange-traded contracts which are called futures contracts and over-the counter contracts which consist of forward contracts and swaps.
Forward contract – a contract is agreed at one point in time, the performance is in line with the terms of the contract and settlement occurs at a subsequent time. The forward contracts discussed are ones which involve an exchange of one asset for another with the price agreed in the initial contract. Forwards are often non-standardized contracts and are traded in unregulated markets, so the parties bear the counterparty risk, i.e. that the party who bears a loss as a result of the transaction defaults on the payment.
Futures contract – futures are a form of forward contract since one party agrees to accept or deliver an underlying asset, or cash equivalent, to another party, at a future expiration date, at a price determined at the beginning of the contract. A futures contract differs from a forward contract since it has standardized contract terms and is traded through an exchange. The contract is effectively guaranteed by the clearinghouse (a financial institution associated with the futures exchange). A deposit (margin) must be deposited at the clearinghouse by futures traders.
Swap – this is an agreement between two parties (the counterparties) to exchange a series of cash flows over a period of time(the tenor) in the future. It is effectively a series of forward contracts.
These cash flows are often dependent on exchange rates (currency swaps) or interest rates (interest rate swaps). The swap market is largely unregulated and parties must take into account counterparty risk.
Whereas a forward contract is binding on both parties, the other category of derivatives is contingent claims. They are often referred to as options and here a payoff occurs only if a specific event takes place.
Options - these are either call options or put options. The holder has the right to buy (a call option) or sell (a put option) an underlying asset at a pre-specified price (the exercise price or strike price) up to/at a certain date. It is important to differentiate between a future where the holder has the obligation to buy or sell and an option where the holder has the choice whether to buy or sell. The seller of the option is the option writer; he/she receives a payment from the buyer but is obliged to buy or sell the underlying asset if the holder of the option wishes to do so.
The payment is the option price, sometimes called the option premium.
Options can be either exchange-listed or over-the-counter. If they are exchange-listed they are standardized contracts and guaranteed by the exchange, whereas with over-the-counter options there is the possibility that one party will default.
Several types of financial instruments contain options and are forms of contingent liabilities.
These include convertible bonds where the holder can decide whether to participate in a rise in the underlying stock price, callable bonds where the issuer can buy back the bond prior to maturity and asset-backed securities where the borrower holds a prepayment option.
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