# Derivatives Basics – Derivative Types

## Derivatives Basics – Derivative Types

### posted By : Nauman Mir

This blog introduces the main types of financial derivatives and examines the purpose served by each type of derivative. Before discussing the types of derivatives, it is important to classify the financial assets that serve as the underlying assets in derivative instruments.

## Types of derivative underlying assets

The underlying assets can be divided into broad categories:

• Equities, currencies, commodities and indices. For these types of assets, we do not care about the absolute value of the assets, but rather the asset returns (i.e. the percentage change in the value of the asset). For example, if some one wants to invest $1000 in a stock, they do not care if the share price of the stock is$1 or $100. If it is$1, they will buy 1000 shares. If it is $10, they will buy 100 shares. The main thing that they care about is the return on the$1000 investment – i.e. the change in the share price.
• Interest rates, bonds and volatility. For these types of assets, the absolute value is important. For example, an interest rate of 5% is different from an interest rate of 0.5%.

Quantitative finance is all about building probabilistic models that try to predict the future values of financial assets. Dividing the assets into the above two categories is important due to the fact that we either model asset returns or their absolute values. Later on, we will discuss in much greater detail the models that drive the valuation of derivatives.

## Main types of financial derivatives

The financial derivatives can be classified into following main categories.

• Forward
• Options
• Bonds
• Swaps

This blog provides a high level introduction to these derivatives. Details like the flavours, valuation and risk management for various types of derivatives will be discussed in detail in subsequent blogs.

## Forward

A forward contract is an agreement between two parties to buy or sell a given quantity of an asset for an agreed upon price and date in the future. Forwards are examples of OTC (Over the Counter) contracts. OTC contracts are ‘custom’ and bilateral agreements signed between counter parties without involvement of an exchange. This means that any credit risk due to the possibility of counter party defaulting has to be managed by the parties themselves. We will examine the role played by exchanges, various types of risk and how to handle them (including credit risk) in much greater detail in subsequent blogs on risk management.

### Use of forward contracts

Forward contracts are used by both hedgers and speculators in the market. As discussed in the introduction blog, hedgers are typically businesses and corporations that use derivatives (in this case, forward contracts) to mitigate the risk associated with various assets. Speculators on the other hand, take a view on the future prices of assets and use forward contracts to bet on the future asset prices.

The forward contracts can be created on any type of underlying. Examples of underlying assets are foreign exchange (FX) rates, stocks, and commodities like grains, metals, oil and so on.

### Future contracts

Forward contracts can also be standardised and listed on the exchange. A standardised contract has well-defined quantity for the asset and exchange date. Listed contracts are called futures and are less risky in terms of credit risk since the credit risk is managed by the exchange.

# Options

An option is a contract between two parties that allows one party the right but not the obligation to buy or sell an underlying asset for a given price in the future from the other party. The agreed upon price is called the strike price. The future date at which the option buyer can choose to buy or sell (exercising the option) the underlying is called the maturity of the option.

### Types of options

An option can be thought of as insurance against adverse movements of asset prices. For a fee (option premium), the option buyer gets the right to buy or sell a fixed amount of asset for the strike price upon maturity. An option that gives its buyer the right to buy underlying asset is called call option. An option that gives its buyer the right to sell an asset is called put option. The key feature of option contract that sets it apart from other types of derivative contracts is the fact that it gives the option buyer the right to sell or buy underlying asset but not the obligation.

### Use of options

Just like other derivatives, option contracts are used by both hedgers and speculators. A hedger uses the option contract to guard against volatility and adverse movements of the asset prices. Volatility is a measure of the fluctuation in the asset price over a given period of time and is one of the most important risk factors that needs to be managed. We will introduce a formal definition of volatility later on along with a discussion on how to measure and risk manage volatility of asset prices.

Speculators also use option contracts to take a view on the future volatility and/or asset prices and make money if proven right. If a speculator thinks that the volatility of an asset going forward would be low, they can make money by selling out-of-money options (money made is the option premium charged by the option seller) on the given underlying asset. Low volatility means that there is little chance that the option will be in-the-money and hence exercised. The option moneyness, valuation, usage and risk management will be discussed in detail in blogs on options.

Similar to forwards, options can be created on any type of underlying asset. The most common type of underlying assets are stocks, interest rates, FX rates and commodities.

# Bonds

Bonds are tradeable loan agreements. In its simplest form, a bond involves payment of an amount (known as principle) at a certain date in the future, known as the maturity date. At the maturity date, the bond holder receives the specified amount from the issuer of the bond. Bonds are tradeable as the bond holder can sell the bond to some one else for a price (typically less than the principal amount when interest rates are positive). At the maturity, whoever holds the bond gets the money paid to them by the issuer of the bond.

### Use of bonds

Bonds are issued by corporations, municipalities, countries etc (essentially any entity that has got a credit rating and some trust in the market that the money will be paid by the entity). These entities issue bonds when they need to raise capital. For example, a city needs money to fund a new water treatment plant costing $50 million. The city issues 50 bonds, each with a principle value of$1 million and a maturity date of 5 years. These bonds are then sold to investors. The key thing to note here is that the investors buy the bonds from the city at a price that is less than $1 million. For example, the investors pay$950K for each bond to the city. After 5 years, the city pays the bond holders the principal amount and the difference of $50K between the principal amount and the price paid for the bond is the profit earned by the investors. Also, an investor does not need to hold on the bond for 5 years until the bond maturity. The original investor can sell the bond to some one else for a price, say$960 after a year. The difference of $10K between the original price paid and the sell price is the profit made by the original investor after a year. The second investor can either hold on to the bond for another 4 years and make a profit of$40K, or sell it on earlier for a smaller amount of profit.

Since bonds are issued by mostly trust worthy authorities, they are considered to be safer investment than say investing in stocks. However, not all bond issuing entities are the same, and the price an investor is willing to pay to purchase the bond depends to a large extent on the credit worthiness of the bond issuer. In later blogs, we will discuss in detail the various types of bonds, how to calculate the fair value of bonds, and manage the risk associated with holding bonds.

# Swaps

A swap contract is an agreement between two parties to exchange a fixed number of cash flows over a given period of time. The size of the cash flows are based on percentages of a capital amount, called the notional of the swap. The set of cash flows payed by each party are collectively called the legs of the swap. If the cash flows of a leg are based on a fixed percentage of the notional, the leg is called fixed leg. If the cash flows of the leg are a variable percentage of the notional, the leg is called floating leg.

The diagram below shows the structure of a fixed-floating swap agreement (Consists of one floating and one fixed leg).

An example of a swap contract is a fixed-floating interest rate swap (IR Swap). The party paying the fixed payments agrees to pay to the counter party a fixed percentage of the notional over a certain period of time at a certain frequency. The party paying the floating payments agrees to pay a percentage of the notional based on the current values of some reference rate like LIBOR. Lets consider the following concrete example that will explain both the structure and motivation for using IR swaps.

### Use of Swaps

Consider the example of a business that needs $1M to invest in some equipment in order to expand. The business prefers to pay fixed rate on the loan as it does not want to expose itself to the fluctuations in variable interest rates. Unfortunately, the business is unable to find a good fixed rate in the market. It however, can find a loan with a competitive variable rate that is a small spread, say 20 basis points (0.2%) over the LIBOR rate from a bank B1. The loan needs to paid back after 5 years, with two interest payments every year. The business gets the loan from B1 with variable rate and then enters into a swap agreement (with notional of$1M) with another bank B2. The business agrees to pay B2 a fixed rate of 2%, whereas B2 pays the business LIBOR + 18 basis points percentage of the notional every 6 months.

The total cost to the business for the two sets of agreements is the sum of the payments that it receives minus the payments that it makes. This would be:

Total cost = LIBOR + 18bps – LIBOR – 20bps – 2% = -2 bps – 2% = -2.02%

The business has now in practice, managed to replace the floating payments it makes to B1 with fixed payments at a rate of 2.02%. This removes the risk associated with the increase in the LIBOR rate over the course of the duration of the loan the business takes from B1 without having to borrow at noncompetitive rates. In this example, the business is the hedger, whereas bank B2 is the speculator. Bank B2 can make money if the LIBOR rate stays low but can potentially loose money if LIBOR goes above the 2% that it receives from the business.

# Summary

In this blog, we learnt:

• The four main classes of derivative products. Most financial derivatives, no matter how complicated, belong to one of the four categories introduced here.
• How financial derivatives are used to manage risks associated with various types of assets.