An Introduction to the World of Derivatives

To the mainstream audience, the derivatives market appears to be a nebulous one – perhaps this has to do with the lack of coverage on derivatives market by mainstream financial media. This could also be due to the lack of transparency of the derivatives market given that a significant portion of transactions are ‘over-the-counter’ (OTC). This type of trading is done directly between two parties, without the supervision of an exchange. It is contrasted with exchange trading, which occurs via exchanges that must be well standardized. The terms of each OTC derivative contract is unique to the transaction and is not sold in public exchanges. The lack of knowledge on the derivatives market is dangerous to aspiring investors. Not understanding how derivatives work is akin to a soldier who goes into modern-day war with a knife as he does not know how to operate a gun. This article will discuss the main uses of derivatives for investors: risk management, access to new investment opportunities, and most interestingly discovering new information of the underlying asset. The exact pricing models of each derivative will be omitted and having an appreciation of the importance of derivatives would suffice for this article.

Derivatives are financial instruments whose performance is ‘derived' from the performance of underlying assets (e.g equities, commodities or bonds). Most simply, bonds represent debt obligations – and therefore are a form of borrowing. You can think of them as an IOU and includes details of how/when the debt will be repaid. A commodity is a basic good used in commerce that is interchangeable with other commodities of the same type. Commodities are most often used as inputs in the production of other goods or services. Common classes of derivatives include forwards, futures, swaps, and options (to be explained below.)

Risk Management

Below are some of the most basic use cases of derivatives in managing risks (in fact you can understand how each derivative work without research just by reading this section). There are more complicated risk management techniques with sophisticated use of complex derivatives, but our aim is merely to allow you to understand the use case of derivatives. These basic use cases of derivatives should be sufficient to drive across the message.

Put Option

A put option gives the holder the right, but not the obligation, to sell the underlying asset at a fixed price. This right can be exercised on a specific expiration date or any time prior to the expiration date. Of course, purchasing a put option is not free and the holder pays the seller of the option a ‘premium’. If I own 100 Apple stocks and I fear that Apple stock prices will fall in the near future, I will purchase a put option to guarantee that the sale of Apple stocks does not fall below a specific price. If the Apple stock price fell as predicted, I can exercise my right as the put option holder to sell my stocks at the specified price, and I have effectively ‘locked-in’ my profit or eliminated additional loss.However, since I am not obligated to sell the stocks, if the apple stock rise in prices, I can just leave the option to expire and sell the stock at market price. One can immediately see how put option is necessary in hedging risk for long equity investors (or any other investors who long other types of assets).

Futures

A future contract is a standardised derivative contract (traded on an exchange) where one party will purchase an underlying asset from the other party (the seller) in the future at a specified price. While futures are very similar to options, the main difference lies in the fact that the future holder is obligated to purchase the underlying asset from the other party – they cannot ‘leave’ the future to expire worthless like in the case of an option. For non-financial companies like airline companies, oil futures are essential in ensuring predictable costs as they eliminate the ambiguity of fluctuating oil prices – airline companies can purchase oil futures to ‘lock-in’ the price for which they are able to purchase oil and do not have to worry about soaring oil prices. Farmers can also sell commodity futures to ‘lock-in’ the price for which they are able to sell their produces and do not have to worry that the price of their produces will fall.

Swaps

A swap is an OTC derivative contract where two parties agree to exchange a series of cash flows, and the nature of each cash flow differs – one party could be paying a variable cash flow while the other pays a fixed cash flow. To see how a swap works, if I am a company that took out a floating rate loan from a bank, I would prefer a fixed rate in order to better predict my future cash flow needs in making my interest payments. I can convert my floating rate loan into a fixed rate loan by purchasing an interest rate swap with a swap dealer. What would happen is that the swap dealer will pay floating rate payments to me that exactly match the terms of the floating rate loan which I can use to pay the bank, while I just have to pay fixed interest payment to the swap dealer. For an investor with a portfolio that has variable interest income, they can also adopt a similar swap arrangement as described above to eliminate interest rate risk.

Access to new investment opportunities

Creative use of derivatives can allow investors to access new investment opportunities and earn additional returns. For example, if an equity investor believes there will not be much movement or volatility in the stock he currently owns in the near future, rather than selling his stake, he can retain his stock holdings and earn an additional source of income from selling a call option. A call option gives the holder the right, but not the obligation, to buy an underlying asset at an agreed price on or before a fixed date to other investors – this way, he does not have to liquidate his stock holdings but can earn premiums from the sale of the call option. If the stock does not show any price movements, the holder of the call option will just leave the option to expire as he will not enforce his right to purchase the stock at the exercise price, which is higher than the current market price. On the other hand, when the stock price rises, the holder of the call option will benefit as he will exercise his right to purchase the stock at the exercise price instead of the higher market price. As such, this strategy is not suitable if you are bullish about the stock price movements as this strategy will cap your earnings at the option exercise price. Nevertheless, from this example, we can see that even in quiet market times, one can utilise derivatives to unlock additional sources of return.

Investors can also have customised investment opportunities through the use of structured products – they are highly customised financial instruments that combine vanilla securities with derivatives to tailor specific investment needs of investors not available in standardised financial products. Let’s create a structured product to demonstrate its mechanics: let’s name this structured product ‘Mark Yeo’s FTSE 100 Defensive Autocall Plan’. Ignoring the fancy jargonised name, this product offers 10% for each year invested (not compounded) provided the value of the FTSE 100 Index is above 100% of its original value in year 2, 3 and 4, 95% in year 5 and 90% in year 6. So an investor who purchase this structured product can potentially earn 10% for 6 years even if the FTSE 100 index only increased by lets say 2% (as long as the FTSE 100 Index is above the specified level of its original value). If for that year, the FTSE 100 Index falls below its required level at any given year (let’s say the FTSE 100 in year 3 is 80% of its original value), the 10% is not paid out, but the initial investment will be returned in full and the structured product matures early. So, there is an embedded ‘down-side protection’ in this structured product.

So how do I create ‘Mark Yeo’s FTSE 100 Defensive Autocall Plan’? Using the money invested by the investor who purchased the product, the structurer will use the proceeds to buy a discounted zero-coupon bond and a put option referencing the FTSE 100 index. If the FTSE 100 index falls below the specific level, the structurer exercises the put option and earn the exercise value of the FTSE 100 that is agreed on the option contract (index options are always cash-settled, no actual stocks are bought or sold) and uses the proceeds to return the capital to the investor who purchased the product. The put option is key in embedding the ‘down-side protection’ in the structured product.

Whilst you can take some time to appreciate the underlying mechanics of a structured product, the key message from this illustration is that financial institutions can combine derivatives and vanilla securities in infinite ways to create customised investment solutions according to the investor’s risk and return preference.

Discovering new information about the underlying asset

What may be less discussed and well-known is the fact that derivatives prices actually give insights about the future prices of the underlying asset. There are vast literature that examines the price to price relationship between derivatives market and the market of the underlying assets and show that the prices in derivatives market lead the prices in spot market. This makes intuitive sense – to illustrate this, let’s take the example of an option and equity. For advanced investors who understands the pricing model of an equity option (‘Black-Scholes Option Pricing Model’), they would realise that the variables that affect an option price are the current price of the underlying asset (the equity), options strike price, time until expiration, implied volatility and risk-free interest rates. All of the variables are observable from public market data except ‘implied volatility’. The price of the option itself is also observable, so an advanced investor can work backwards to find the implied volatility attached by investors to the underlying equity – this gives a huge information discovery regarding the future of the underlying equity price movements. This method of discovering new information about the underlying asset does not apply only to options and equity. By understanding the mathematical pricing models of derivatives, we can work backwards to gain insights about the future price movements of the underlying asset (which can be bonds, currencies, equities etc) given that the price of the derivative is readily observable from market data, and astute traders can use such informational advantage to make good trading decisions.

This article attempts to touch the surface of a multitude of topics regarding derivatives, and I hope this article has given you some useful insights about the actual use of derivatives in the financial world. In fact, the use of derivatives is not limited to investors, and non-financial companies are increasingly using derivatives to achieve their financial objectives (this can be discussed in a separate article in the future).