Derivatives: Basics

Since 'Derivatives' are so much talked about these days and we haven't covered it in this blog, let me talk something basic about Derivatives. As we know, Derivatives are financial instruments which derive its value from one or more underlying asset (from the word 'derived'). Though underlying price is the most dominant factor in the price of a derivative, other things like risk free rate, volatility in the underlying, duration of the contract, kind of settlement, etc. are few other factors that help in determine the price of a derivative instrument.

So, the more important question which arises is why do we need derivatives? Why can't we straight away trade in the underlying? Well, we need derivatives to hedge the risk. In a developed market, everyone wants to hedge his/her risk and derivatives help him/her to do so. An example for this can be a farmer who wants to sell potatoes after two months when he will harvest his produce. He knows that in future, prices may go up or down. He knows the approximate produce that he is going to have but have to wait for two months to get the physical commodity(Potatoes) to sell in the market. What if prices fall by this time? This is a big fear for the farmer. On the other hand lets assume a chips manufacturing company which has secured a huge order for potato chips to be delivered after 3 months and it required potato supply after two months. The company fears the prices may go up and reduce its profitability. Here is a typical situation in which the two complementary parties share a common risk and are willing to reduce it. What if the farmer and the company agrees to have the deal that farmer will sell a fixed quantity of potatoes to the company after two months at some price which is fixed today. So, they enter into an forward contract ( a kind of derivative instrument, since the price at which contract is done is dependent on the price of potato, the underlying commodity). This way, the farmer and the company hedges the risk. (for farmer, risk is of prices going down in future, while for company, the risk is of prices going up).

Now, coming to the types of derivatives, lets start with the forwards contract. In forwards contract, buyer agrees to buy specific quantity of goods from seller at a fixed price (futures price) on a future date. So in the above example, suppose the company agrees to buy 100 kg of potatoes at 10Rs/Kg after 3 months from now, it will be a forwards contract. Now, in these type of contracts the major problem is of default risk. If prices go up then farmer will try to default and if prices go down then company will try to look for other sellers. Hence, futures contracts are used. In futures, contracts are more standardized and are traded on a future exchange. default risk is taken care by margin which is charged by the exchange from both buyer and seller. Most contracts are settled through cash settlement. Margin requirements can be reduced or waived off for those who have physical ownership of the commodity.

Now we come to the question as to how to decide on the futures price. Now the futures price has to be greater than the spot price else, people will make profit. This can be seen from the following example. Say, If spot price is 100 Rs and futures price is also 100 Rs, then a person will buy futures of 100 Rs and sell stock of 100 Rs. He will earn interest on those 100 Rs which will be his profit (arbitrage). So, future price is always higher than spot price. Theoretically future price is calculated by continuous compounding and is given by S * exp(r*t) where S is spot price, r is rate of interest (risk free rate) and t is fraction of time. Now, if theoretical futures price is greater than actual futures price, then the asset is underpriced and we will like to buy futures and sell stock. And if theoretical futures price is lower than actual futures price, then the asset is overpriced and we will like to sell futures and buy stock. Theoretical futures price will eventually tend to be equal to spot price as we approach the maturity date. This is termed as principle of convergence. Difference of spot price and future price is defined as basis (spot price – future price). When difference increases, we say that basis strengthens and is good for short hedger. When difference decreases, we say that basis weakens and is good for long hedger.