DERIVATIVES: TYPES

CLASS:III BCOM GEN

SUBJECT: Fundamentals of Stock Market

Unit: 3

Topic: Derivative Market, Commodity Market and Currency Market

Course Teacher: G.Vincent, Associate Professor,SRM IST,Tiruchirappalli Campus

 

Derivative- Definition

A derivative is a financial contract whose value is derived from the performance of an underlying asset, group of assets, or benchmark. A derivative itself has no intrinsic value; it is essentially a bet or a contract on the future price movement of something else.

The "Underlying Asset"

The "something else" that a derivative is based on is called the underlying asset. This can be almost anything that has a fluctuating value, including:

• Equities: Individual stocks (e.g., Apple Inc.) or stock market indices (e.g., the S&P 500).
• Commodities: Raw materials like crude oil, gold, wheat, and natural gas.
• Currencies: Foreign exchange rates (e.g., EUR/USD).
• Interest Rates: The rates charged on borrowing money (e.g., LIBOR or government bond rates).
• Bonds: Debt instruments issued by governments or corporations.

Core Analogy to Understand Derivatives:
Imagine you and a friend make a bet in June on the price of a concert ticket for a show in December. You agree that if the ticket price goes above $100, your friend will pay you the difference. If it stays below $100, you pay them nothing. This bet is a derivative. Its value depends entirely on the price of the underlying asset (the concert ticket). You are trading the risk of the price changing without ever owning the ticket itself.

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The Derivatives Market

Introduction

The derivatives market is one of the largest and most important parts of the global financial system. While it can seem complex, its core purpose is to manage and transfer risk. This guide will break down the fundamental concepts of what derivatives are, their key characteristics, and the main types you will encounter.

2. Key Features of Derivatives

Understanding these features is crucial to understanding how the market works.

1. Value is Derived: This is the most fundamental feature. The contract's value is directly linked to the price of its underlying asset. If the underlying asset's price doesn't change, the derivative's value won't change either.
2. Contractual Agreement: A derivative is a binding contract between two or more parties. It specifies the terms of the deal, such as the underlying asset, the quantity, the price, and the expiration date.
3. Leverage: Derivatives offer high leverage, meaning you can control a large amount of the underlying asset with a relatively small amount of capital (called a "margin").
• Effect: Leverage magnifies both potential profits and potential losses. A small price movement in the underlying asset can lead to a very large change in the value of the derivative contract. This makes derivatives powerful but also very risky.
4. Used for Hedging (Risk Management): This is the primary and original purpose of derivatives. Hedgers use derivatives to protect themselves against adverse price movements in the future.
• Example: An airline company expects to buy a large amount of jet fuel in six months. They fear the price of oil will rise. They can buy an oil futures contract today to lock in the price, thus hedging against the risk of rising fuel costs.
5. Used for Speculation: Speculators use derivatives to bet on the future direction of an asset's price in an attempt to make a profit. They accept the risk that hedgers want to offload.
• Example: A trader believes the price of gold will increase. Instead of buying physical gold, they can buy a gold futures contract. If they are right, they can sell the contract later at a higher price for a profit. Speculators provide essential liquidity to the market.
6. Future-Oriented: The agreement is made today, but the actual transaction or settlement is scheduled for a specific future date.

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Comparison Table: Derivatives Market vs. Spot Market

This table clearly illustrates their opposing characteristics:

Feature	Derivatives Market	Spot Market (Cash Market)
What is Traded?	Financial contracts (Futures, Options, etc.) whose value is derived from an asset.	The actual, physical underlying asset (e.g., a barrel of oil, a share of stock, a bar of gold).
Basis of Value	Based on the expected future value of the underlying asset.	Based on the current market price of the asset, determined by immediate supply and demand.
Settlement	On a specified future date. The contract expires in the future.	Immediately or within a very short period (e.g., T+2, meaning transaction day + 2 days).
Ownership	No immediate ownership of the asset. You own a contract, not the thing itself.	Ownership of the asset is transferred directly from seller to buyer.
Primary Purpose	Hedging (managing risk) and Speculation (betting on price movements).	Investment, consumption, or actual use of the asset.
Example	Buying a futures contract that gives you the obligation to buy 1,000 barrels of oil in 3 months at $80/barrel.	Going to the market and buying 1,000 barrels of oil today at today's price of $78/barrel for immediate delivery.

 

A Simple Analogy: Buying a House

To make it even clearer, let's use a real-world analogy:

• Spot Market Transaction: You find a house you like, agree on a price, pay the money, and sign the papers. The deed is transferred to you, and you own the physical house right away. This is a spot transaction.
• Derivatives Market Transaction: You believe house prices in a neighborhood will rise. Instead of buying a house, you pay a builder $10,000 for an option contract. This contract gives you the right (but not the obligation) to buy a specific house for $500,000 six months from now.
• You don't own the house; you own a piece of paper (a contract).
• The value of your contract is derived from the value of the house.
• You are speculating on the future price of the house.

 

 

3. Types of Derivative Markets and Contracts

Derivatives are mainly classified into four basic types. They can be traded either on a formal, centralized exchange or Over-the-Counter (OTC) in a private transaction.

A. Forwards

• What it is: A customized, private contract between two parties to buy or sell an asset at a specified price on a future date.
• Trading Venue: Over-the-Counter (OTC). The terms (price, quantity, date) are privately negotiated between the buyer and seller.
• Key Features:
• Customizable: Highly flexible to meet the specific needs of the parties.
• Private: Not publicly disclosed.
• Primary Risk: Counterparty Risk. Since it's a private agreement, there is a risk that one party will fail to meet their side of the bargain (default).

B. Futures

• What it is: A standardized contract to buy or sell an asset at a predetermined price at a specified time in the future.
• Trading Venue: Centralized Exchanges (e.g., Chicago Mercantile Exchange - CME).
• Key Features:
• Standardized: The contract size, quality of the asset, and delivery dates are all fixed by the exchange. This makes them easy to trade.
• Exchange-Guaranteed: The exchange acts as a middleman (a clearinghouse) between the buyer and seller, guaranteeing the transaction.
• Primary Risk: Market Risk. The exchange eliminates counterparty risk, but you can still lose money if the market moves against your position.

C. Options

• What it is: A contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a set price (the "strike price") on or before a specific date.
• Trading Venue: Mostly traded on exchanges, but can also be OTC.
• Key Features:
• The buyer pays a fee called a premium for this right.
• Two Types:
1. Call Option: Gives the owner the right to buy the asset. (You use this when you think the price will go up).
2. Put Option: Gives the owner the right to sell the asset. (You use this when you think the price will go down).
• Primary Risk: For the buyer, the maximum loss is limited to the premium they paid for the option. For the seller, the potential loss can be unlimited.

D. Swaps

• What it is: A private agreement between two parties to exchange sequences of cash flows for a set period of time.
• Trading Venue: Almost exclusively Over-the-Counter (OTC).
• Key Features:
• Most commonly used for currencies and interest rates.
• Interest Rate Swap: One party exchanges their variable-rate interest payments for the other party's fixed-rate payments.
• Currency Swap: Parties exchange principal and/or interest payments in different currencies.
• Primary Risk: Counterparty Risk, as these are private OTC agreements.

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Summary Table: Comparing Derivative Types

Feature	Forwards	Futures	Options	Swaps
Contract Type	Customized	Standardized	Standardized	Customized
Trading Venue	Over-the-Counter (OTC)	Exchange-Traded	Exchange-Traded	Over-the-Counter (OTC)
Counterparty Risk	High	Very Low (clearinghouse)	Very Low (clearinghouse)	High
Obligation	Obligation to buy/sell	Obligation to buy/sell	Right, not obligation	Obligation to exchange
Primary Use	Hedging specific needs

A Beginner's Tutorial on the Commodity Market

Introduction: What is a Commodity?

A commodity is a basic good or raw material used in commerce. The key feature of a commodity is that it is fungible, meaning it is interchangeable with other commodities of the same type. For example, one barrel of Brent crude oil is the same as any other, and one bushel of Grade A wheat is the same as another.

Commodities are broadly categorized into:

1. Metals: Gold, Silver, Copper
2. Energy: Crude Oil, Natural Gas
3. Agriculture: Wheat, Corn, Soybeans, Coffee, Sugar
4. Livestock: Live Cattle, Lean Hogs

Why Do We Trade Commodities?

1. For Producers & Consumers (Hedging): A corn farmer can sell a futures contract to lock in a price for his crop before it's even harvested. A company like Kellogg's can buy that contract to lock in the price of corn they need for their cereal. This removes price uncertainty for both.
2. For Investors (Speculation): Traders bet on the future price of commodities to make a profit. This activity provides the essential liquidity that allows hedgers to easily find buyers and sellers.

How Can You Participate in the Commodity Market?

1. Futures Contracts (The Professional's Way):
• This is the most direct way to trade commodities. You buy or sell a futures contract on an exchange.
• Pros: High leverage, direct exposure.
• Cons: Very complex, extremely high risk. Requires significant capital and knowledge. Not recommended for beginners.
2. ETFs and Mutual Funds (The Beginner's Way):
• Exchange-Traded Funds (ETFs) are funds that trade on a stock exchange. You can buy an ETF that tracks the price of a single commodity (like a Gold ETF) or a basket of commodities.
• Pros: Easy to buy and sell through a standard brokerage account. Low cost. Diversified. You don't have to deal with complex futures contracts.
• Cons: May not perfectly track the commodity's price due to fund management fees and contract rolling costs.
3. Stocks of Commodity-Producing Companies (The Indirect Way):
• You can invest in companies that produce the commodity. For example, instead of buying oil, you buy shares in an oil company like ExxonMobil or Shell.
• Pros: Simple to understand if you already invest in stocks.
• Cons: You're exposed to company-specific risk (e.g., poor management, an oil spill) in addition to commodity price risk. The stock price may not always move in line with the commodity price.

What Affects Commodity Prices?

• Supply and Demand: The most important factor. A drought could reduce the supply of corn, raising its price. A global recession could reduce demand for oil, lowering its price.
• Geopolitics: Conflict in the Middle East can disrupt oil supply and cause prices to spike.
• Weather: Hurricanes, floods, and droughts have a massive impact on agricultural commodities.
• The US Dollar: Most major commodities are priced in U.S. dollars. When the dollar gets stronger, it takes fewer dollars to buy a barrel of oil, so the price of oil tends to fall (and vice versa).

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Part 3: A Beginner's Tutorial on the Currency Market (Forex/FX)

Introduction: What is the Forex Market?

The Foreign Exchange (Forex or FX) Market is the global marketplace where currencies are traded. It is the largest and most liquid financial market in the world.

Unlike a stock market, there is no central exchange. Trading is conducted 24 hours a day, 5 days a week, over a network of banks, corporations, and individual traders.

The core concept is that you are always trading currencies in pairs. When you buy the EUR/USD, you are simultaneously buying Euros and selling U.S. Dollars.

How to Read a Currency Pair

Let's use the example: EUR/USD = 1.08

• Base Currency (First): EUR. This is the currency you are buying or selling. It always has a value of 1.
• Quote Currency (Second): USD. This is the currency you are using to make the transaction.
• The Rate (1.08): This means that 1 Euro is worth 1.08 U.S. Dollars.

If you believe the Euro will get stronger against the Dollar, you would BUY the EUR/USD pair.
If you believe the Euro will get weaker against the Dollar, you would SELL the EUR/USD pair.

Key Forex Terminology for Beginners

• Pip (Percentage in Point): The smallest unit of price movement. For most pairs, it's the fourth decimal place (e.g., if EUR/USD moves from 1.0800 to 1.0801, that is a 1 pip move).
• Spread: The tiny difference between the price you can buy a currency at (the ask price) and the price you can sell it at (the bid price). This is how brokers make their money.
• Leverage: Forex brokers allow you to use leverage to control a large position with a small amount of money. For example, with 100:1 leverage, you can control $100,000 worth of currency with just $1,000 in your account. Warning: Leverage magnifies both profits and losses and is extremely risky.
• Lot Size: The size of your trade. Standard Lot = 100,000 units of the base currency. Beginners often trade with Mini Lots (10,000) or Micro Lots (1,000).

What Affects Currency Prices?

The value of a country's currency is like a report card for its economy.

1. Interest Rates: The single most important driver. Higher interest rates attract foreign investment, increasing demand for and strengthening the currency. Central bank decisions are watched very closely.
2. Economic Data: Reports on GDP (economic growth), inflation, retail sales, and employment numbers all impact currency value. Strong data usually leads to a stronger currency.
3. Political Stability: A stable government and political climate are seen as positive. Instability and conflict weaken a currency.
4. Market Sentiment & Speculation: If traders believe a currency is going to rise, they will buy it, which in turn causes it to rise. It can be a self-fulfilling prophecy.