Derivative Financial Instruments - All You Need to Know

Derivatives, as the word suggests, are contracts and not investments. They are referred to as derivatives because their value is derived from an underlying asset. That underlying asset could be an equity stock, an index, a bond, a commodity, a bond index, a commodity index, forex currency pairs, cross currency pairs etc. Financial derivatives can also be traded on concepts like volatility by buying or selling derivatives on the VIX.

Derivatives broadly fall into four categories:

Forwards are an agreement to buy or sell an underlying asset at a future date at a fixed price in the over the counter (OTC) market.

Futures are exactly like forwards, the only difference being that they are traded on a recognised stock exchange and they are standardised with reference to lot sizes and expiry periods.

Options are a right to buy or sell an underlying asset, popularly referred to as call and put options.

Finally, there are swaps which entail exchanging a set of cash flows for another; fixed versus floating rates or one currency versus the other.

Popular derivative contracts available in India

While derivatives have historically existed for more than hundred years in different forms, the derivatives in an organised form on the exchanges are just about 16 years old. Here are some popular derivative products available in India.

1. Rupee forwards offered by authorised banks (Forward Cover)

2. Stock futures and options on the NSE and BSE

3. Index futures and options on the NSE and BSE

4. Commodity futures and options (industrial metals, agri, energy and precious metals)

5. Interest rate futures (IRFs)

6. Volatility futures (futures on the VIX)

7. Rupee pairs (USDINR, EURINR, GBPINR and JPYINR) futures and options

8. Cross currency pairs (non-rupee) futures and options

These represent the most popular types of derivative products available for trading in India and most of them are liquid and actively traded. The derivative market has to been seen in contrast to the spot market for assets.

Some specific features of derivative contracts

Any derivative contract has some unique features. Remember, derivatives are contracts and not assets. Hence, you don’t hold derivatives contracts in your demat account. Here are some unique features of such derivative contracts.

• Derivative contracts have counterparties. For every derivative contract, there has to be a buyer and seller. This is the case in OTC forward contracts since it is a private contract. However, in case of exchange traded derivatives like futures and options, the Clearing Corporation of the stock exchange acts as the counterparty to every transaction.  This ensures there is no risk of default.

• Forwards and futures are fairly straight forward. They just have a spot price and a futures price. Options can be a lot more complicated. There is a strike price, which is the price at which it may be exercised. For every underlying asset there are multiple strike prices. In addition, options are also driven by volatility.

• Unlike stocks where the view is bullish or bearish; derivatives are a lot more nuanced. There can be a bullish view, bearish view, moderately bullish view, moderately bearish view, volatile view, range-bound view or even a hedge view with limited loss and profit parameters.

• From the above point, it logically follows that investors typically use derivatives for three reasons. The first reason is to hedge a position. You can hedge your equity position by either selling futures or by purchasing lower put options. The second is to increase leverage or speculate on an asset's movement. Here you use derivatives as a proxy for borrowing and trading. This is risky and must be done cautiously. Lastly, derivatives can also be used for arbitrage (riskless profits).

Understanding the all-important options strategies

Futures are plain vanilla. You either use futures as a proxy for long position, short position or to arbitrage spreads with cash price. But options are better known for hybrid strategies. Here are four popular strategies.

Protective Put – Buy a stock and buy a lower strike put. Downside risk is limited and upside profits can be unlimited.

Covered Call – Buy a stock and sell a higher call. The premium on call helps to reduce your cost of holding the stock.

Bull call spread – Buy a lower call and sell a higher call. The higher call premium reduces your lower call premium cost. Profits and losses are limited.

Long Strangle – Buy a higher strike call and a lower strike put. You make profits both ways if the breaches the range.

You can have an elaborate discussion on options strategies but these are the four most popular options strategies in the derivative markets in India.

Getting the hang of swaps

Swaps are not very common in India but it is big globally. In a swap, counterparties exchange cash flows where they perceive a relative advantage. Here are some common swap categories.

Interest Rate Swaps - If one party has a fixed-rate loan but floating rate liabilities, they can enter into a swap with another party and exchange to a floating rate to match liabilities.

Currency Swaps - Interest payments and principal repayments in one currency can be exchanged for another currency based on risk perception.

Commodity Swaps – This entails a swap to exchange cash flows by two parties where flows are dependent on the price of an underlying commodity (gold and silver).

Derivative markets offer the facility to hedge, speculate and exchange cash flows. But it is a high risk game and must be played with caution and expertise.