CHAPTER

03
UNDERSTANDING DERIVATIVES

IMPORTANT CONCEPTS DEFINITIONS/EXPLANATIONS

Derivative contract A derivative contract is a delayed delivery agreement in which its value is
dependent upon or derived from other underlying assets.
Examples of underlying assets of a • Weather (such as the number of days in a month that temperature is
derivative contract above or below a certain level).
• Farm and agricultural outputs (such as soy bean, corn, pork belly).
• Metals (such as gold, aluminium, palladium).
• Energy (such as oil and gas).
• Financials - both physical (such as equity, bond, currency) and
intangible (such as equity index, bond index, interest rates).
• Digital - Cryptocurrencies, Non-fungible Tokens (NFT) and Central Bank
Digital Currencies (CBDCs)
Uses of derivative contracts • Useful hedging tools.
• Directional bets of the price movement of the underlying.
• Risk management tools.
Futures and forwards Futures and forwards are contracts giving the obligation to buy (a “call”
contract) or sell (a “put“ contract) the underlying assets:
• in specified quantity;
• at a specified price (the “delivery price” or “future price”); and
• on a specified future date (the “delivery date” or “settlement date”).
Pricing of forward contracts • Forward price = spot or cash price + cost of carry. Difference between
the spot and the forward price is often referred to as the premium or
discount. That is, the cost of carry is referred to as a premium when it
is positive; is referred to as a discount when it is negative.

MAIN DIFFERENCES BETWEEN FUTURES AND FORWARDS

FUTURES FORWARDS
• Standardised contracts traded • Non-standardised contracts traded over the counter (OTC) between
on exchanges. two parties.
• Subject to margin • Not subject to margin requirements.
requirements. • Settlement of gains / losses only occurs on delivery date.
• There are partial settlements However, since forward contracts are non-standard, features such as
of emerging gains / losses mark-to-market and daily margining may be negotiated into specific
through daily mark-to-market contracts.
process.

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 EXAMPLES OF COMMODITY AND FINANCIAL FUTURES

COMMODITY FINANCIAL FUTURES

Metals – base, precious Interest rates.
Grains and oilseeds – grain, Bond prices.
livestock, oilseeds, fibres
Softs – coffee, cocoa, sugar Currency exchange rates.
Energy – crude oil, gas, oil Equity stock indices.
products

IMPORTANT CONCEPTS DEFINITIONS/EXPLANATIONS

Contango When the futures price is higher than the spot price.
Backwardation When the futures price is lower than the spot price.
Basis Difference between the spot price and the future price.
Initial margin Initial cash outlay.
“Margin call” When the account is below a “maintenance margin” level.
“Variation margin” Additional amount required to restore the account to the initial margin.

MAIN MARKET PARTICIPANTS

WHO REASON FOR BUYING REASON FOR SELLING

Hedgers To lock in a price and obtain To lock in a price and obtain
protection from rising prices. protection from falling
prices.
Speculators To profit from rising prices. To profit from falling prices.

IMPORTANT CONCEPTS DEFINITIONS/EXPLANATIONS

Hedgers Hedgers are typically producers and consumers of the commodity. Buyers
are thus able to protect themselves against higher prices, and sellers are
able to hedge against lower prices.
Speculators Speculators are investors who buy to profit from a price increase or sell to
profit from a price decrease.
Short hedging with futures • A short hedge means to go into a short position to protect an existing
portfolio of stocks.
• In case the market falls, any losses on his portfolio holdings will be
partially offset by the gains from the short futures position. If the
market rises, he loses from the futures position, but gains from the
rise in the portfolio’s value.
Long hedging with stock index Lock in today’s prices to take advantage of the rise in prices if it does
futures occur.
Options and warrants Both give the right to buy (“call” contract) or sell (“put” contract) the
underlying security:
• in specified quantity;
• at a specified price (called the “exercise price”, or “strike price”); and
• on or before a specified date (called the “expiry date”).
Grants the right, but not the obligation.
European style option / warrant A European style option / warrant is a contract that may only be exercised
on expiration.
American style option / warrant An American style option / warrant is a contract that may be exercised on
any trading day on or before the expiry date.

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 INTRINSIC VALUE OF AN OPTION / WARRANT

PUT
CALL (RIGHT TO BUY) INTRINSIC VALUE
(RIGHT TO SELL)
“in-the- money” Strike price is less than market Strike price is more than market Positive value.
price. price.
“at-the money” Strike price is equal to market Strike price is equal to market No value.
price. price.
“out-of-the Strike price is more than market Strike price is less than market No value.
money” price. price.
IMPORTANT CONCEPTS DEFINITIONS/EXPLANATIONS
Plain vanilla option “Plain vanilla option” refers to option with predetermined underlying assets, a
stated strike price, a known expiry date, without special conditions on any of the
option parameters. The value of option is based on a number of factors as follows:
• current spot price of the underlying asset;
• exercise price;
• time until expiry;
• interest rate;
• volatility of the underlying; and
• dividend rate on the underlying.
“Exotic option” “Exotic option”, by contrast, has conditions on any of its parameters. For example,
the payoff under an Asian option is based on the average price of the underlying
assets over a preset period.
Examples of exotic options • Asian option.
• Forward-start option.
• Compound option.
• Chooser option.
• Barrier option.
• Binary option.
• Rainbow option.
• Swaption.
Asian option The payoff is determined by the average price of the underlying assets over a
preset period of time.
Forward-start option The option only comes into effect at a future date.
Compound option As settlement is at expiry, the option-holder receives another option.
Chooser option The investor chooses whether the option will become a call or a put by a specified
choice date.
Barrier option This is the option used in the barrier certificates.
• Up-and-out.
• Down-and-out.
• Up-and-in.
• Down-and-in.
Binary option This option pays off either nothing or a predetermined amount.
Rainbow option The payoff of rainbow options depends on the best or the worst of the risky assets.
For example, best of x number of risky assets, or the worst of, or the maximum of,
or the minimum of.
Swaption This is an option giving the right to enter into an underlying swap agreement.
Bermuda Options Holder of Bermuda options can exercise its options at pre-set dates including of
course the expiration date. It is a hybrid between European options and American
options
Lookback options Holders of lookback options do not have an exercise price at the time of purchasing
the option. Instead, he can choose the most favourable price of the underlying
assets over the duration of the option contract.

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Extendible options This option enables either the buyer or seller of the options to extend the maturity
date of the option by a specified period of time, at their discretion. Hence, it may
come in the form of holder-extendible option in which case the holder has the right
to extend the maturity date, or a writer-extendible option in which case the seller
possesses the right to extend the maturity date of the option.
Shout options The holder has the right to lock in a certain amount of profit when the option
is in-the-money before it expires. Having done that, the holder can continue to
participate in the upside potential in the remaining duration to maturity.
Basic option trading • Bullish Option Strategies
strategies  Long calls;
 Covered calls;
 Protective puts; and
 Selling naked puts.
• Bearish Option Strategies
 Long puts; and
 Naked calls.
• Neutral Option Strategies
 Bear straddles; and
 Bull straddles.
Long calls • Buys only a call option.
• Combination of leverage, limited downside and unlimited upside potential.
Covered calls • A covered call is a conservative strategy where one writes (i.e. sells) call options
on stock already owned (note that we are not newly buying stock).
• Investors write covered calls because they are bullish on the stock that they
own and would like to keep the stock for returns in the long term, but they feel
that the potential of the stock going up is not promising in the near term.
Protective puts • A protective put strategy calls for buying a put on stock that one has already
owned.
• Protective put benefits investors who are mainly bullish about the stock, but
nevertheless want downside protection.
Selling naked puts • Limited profit when the stock goes up and still exposed to great risk when the
stock price goes down.
• When investors wish to own a stock at a discount relative to its current price.
Long puts • Buys only a put option.
• Combination of leverage, limited downside and unlimited upside potential.
Naked calls • Naked call seller is completely exposed to downside risk when the stock price
goes up.
• Downside unlimited, the upside is limited to the premium received.
Bear straddle • Expect the opposite in that the market will not move much in either direction.
• Simultaneously sell a call and sell a put at the same strike and expiration.
• Best situation is for price to not move at all.
Bull straddle • Opposite with a bear straddle.
• Larger the price movement, either up or down, the bigger will be the profits.

SUMMARY OF OPTIONS

BUYER / HOLDER SELLER / WRITER

Right or obligation Buyer has the right to buy or sell – no Seller has the obligation to buy or sell – no
obligation. right to refuse.
Call Right to buy / to go long. Obligation to sell / to go short on exercise.
Put Right to sell / to go short. Obligation to buy / to go long on exercise.
Premium Paid. Received.
Exercise Price OTC options strike price are defined by OTC options strike price are defined by
participants whereas exchange traded participants whereas exchange traded
options follow a standardised criteria for options follow a standardised criteria for its
its exercise price. exercise price.
Max Potential Loss Cost of premium. Unlimited.
Max Potential Gain Unlimited. Price of premium.

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IMPORTANT CONCEPTS DEFINITIONS/EXPLANATIONS
Swaps A swap agreement is exactly what the name suggests, where two parties
agree to exchange cash flows at future dates.
Five types of swap instruments • Interest rate swaps.
• Currency swaps.
• Credit default swap (CDS).
• Equity swaps.
• Commodity swaps.
Interest rate swaps • It is the exchange of the interest payments on a fixed rate loan to the
payments on a floating rate loan.
• Since an interest rate swap operates in the same currency, cash flows
occurring on same dates can be and are netted.
Currency swaps • Both principal and interest payments are exchanged between two
counterparties, at a rate agreed now, at a specified point in the future.
• With a cross-currency swap, both the principal and interest payments are
exchanged without any netting, because the cash flows are in different
currencies, rendering netting impossible.
Credit default swap (CDS) A CDS transfers the credit risk of a credit instrument, namely bond, note or
loan, to another party, in exchange for a series of fee payments. It is similar to
insurance because it provides the CDS buyer, who owns the underlying credit,
with protection against default, a credit rating downgrade, or other defined
“credit events”.
Equity swaps One set of cash flow is equity-based, such as from a stock or from an equity
index. The other set of cash flow is often fixed income-based (either a fixed
rate or floating rate such as LIBOR), but can also be equity-based.
Commodity swaps A commodity swap is an agreement in which one set of payments is set by the
price of a commodity or by the price of a commodity index.
Contract for differences (CFD) • CFD is a contract between an investor and a CFD provider, usually a
broker, that allows investors to speculate on the price movements of an
underlying security, typically a stock, on margin.
• No expiry dates, provided that there is enough margin in the account to
support the position.
• Allow investors the flexibility to trade on both the long and the short sides
of the market. By taking a long position, the investor receives dividends
and pays interest; while by taking a short position, the investor pays
dividends and receives interest.

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