Understanding derivatives

Understanding derivatives

Learn how derivatives are settled and recognise their use in portfolio management

Key takeaways

  • Understand the purpose of derivatives
  • Distinguish between different types of derivatives
  • Understand how derivatives are settled
  • Recognise the use of derivatives in portfolio management

The purpose of derivatives

When it comes to derivatives, the clue is in the name. Derivatives are financial securities that derive their value from other assets such as equities, bonds, commodities or currencies.

The underlying assets

The underlying assets

For asset managers, derivatives are typically used for the following purposes:

1) To hedge positions in a portfolio to reduce risk
2) For efficient portfolio management (EPM) to reduce costs
3) To gain exposure to the directional movement of an underlying asset
4) Income generation
5) To give leverage to portfolios.

Another important advantage of derivatives is convenience. Asset managers can benefit from movements in asset prices without having to buy the assets themselves, allowing them to diversify exposures swiftly and efficiently. It is much easier to buy and sell oil futures, for example, than physical barrels of oil.

Types of derivatives

There are many different kinds of derivatives. Most, however, fall into four broad categories: forwards, futures, options and swaps.

Another important distinction is between derivative contracts that are arranged ‘over the counter’ (OTC) and those that are traded on exchanges.

‘Over the counter’ (OTC) derivatives

These OTC derivative contracts are arranged directly between the two parties involved, with terms agreed between them. Secondary trading – where the derivatives are sold on to other parties – occurs through direct contact between buyers and sellers.

Exchange traded derivatives

By contrast, exchange-traded derivatives have standardised terms and are sold via a central exchange. Their prices are made public throughout. This means that exchange-traded derivatives are typically much more liquid (readily bought and sold) than the OTC equivalents.
  • In June 2022, the total notional amount outstanding for Over the Counter (OTC) contracts in the derivatives market was about $632tn (OTC derivatives statistics at end-June 2022 (bis.org)
  • By contrast, the global bond market is estimated to be about $133tn, and the value of stock markets globally slightly less.

Buying and selling derivatives

Long position – buy

If you are the person buying a derivatives contract, then you are on the long side of the contract. Simply referred to as going long

Short position – sell

If you are the person selling a derivative contract, then you are on the short side of the contract. Simply referred to as going short

The four main categories of derivatives

1. Forwards

Forward contracts, or forwards, are the oldest and simplest kind of derivative. They are used to avoid the effect of volatility in markets, for example commodities. Essentially, a forward contract is an agreement to carry out a trade at a set date and a specified price.
As an example, let us take a fruit farmer who expects to produce a certain amount of pears each year. He usually sells most of his crop to a supermarket chain. When the price of pears rises, that’s usually good for the farmer and bad for the supermarket chain, which has to pay more per pear, hurting its profits. And when the price of pears falls, it’s bad for the farmer, who will make a lower profit on his crop – or, if the price is sufficiently low, a loss.
Credit risk, or counterparty risk, is the risk of a default by the party with whom you have agreed the derivative contract. Essentially, this is the risk that the other party to your contract will be unable to pay up. Credit risk arises chiefly with derivative contracts that are agreed directly between two parties, rather than using a third party as an intermediary or market-maker.

In extreme circumstances, volatility in prices can be ruinous. If there is an unexpectedly good harvest across the country, or if imported pears suddenly become much cheaper, the farmer may find that he makes a huge loss that could bankrupt his business. But if he can fix the price of pears in advance, he avoids that risk.
For the supermarket chain, the risk may be less severe; after all, supermarkets sell a huge range of goods and so are less vulnerable to fluctuating prices for any single product. But certainty is helpful, and if the supermarket managers know what they are going to be paying for a large number of products, they can plan their operations more assuredly.
Another consideration is that the rises and falls in prices might tend to balance out over time. So, by setting a price through a forward contract, the farmer and the supermarket can hope to obtain roughly the same degree of profitability as they would otherwise enjoy – but without the risks posed by drastic shifts in market prices.
The same principle can be applied to a wide range of different assets. Prices can be agreed in advance and, if desired, the contract for delivery can be sold on to a third party.

2. Futures

Futures contracts are similar to forwards. But there’s an important difference. While forwards are OTC products, futures are traded on a public exchange. Their terms are standardised and they avoid counterparty risk because the exchange’s clearing house guarantees payment. The clearing house generally takes collateral payments (margin) from both parties involved in the transaction. This is to limit its losses if one party defaults on its obligations; the clearing house will make good on the obligation in any case.
While forwards tend to be limited to commodities and currencies, futures cover a much wider range of markets, including shares, bonds, market indices and interest rates.
Because futures are exchange-traded derivatives, they can be readily bought and sold – which means that they can change hands many, many times before their settlement date. This liquidity makes them useful instruments for hedging a portfolio’s exposures – as well as for gaining exposure to additional asset classes.
The simplest way of using futures to reduce risk is just the same as with a forward contract: you fix the price now so that it does not matter whether it rises or falls in the future. You accept the risk of missing out on higher profits by eliminating the risk of losses.
But futures can also be used to hedge exposures in a portfolio. For example, you might hedge your active investments in equities with a smaller short position in index futures. While your active investments might suffer in the event of a broad market decline, your futures position would make money to offset this somewhat.
Conversely, if both your active investments and the index rose, you would lose money on your futures position but would hope that your larger active position would more than compensate.
Forward and future

3. Options

Options are similar in many ways to futures.  But there’s a crucial difference. Under a futures contract, the buyer (or long) and seller (or short) are obliged to buy or sell, respectively. An option, as the name implies, does not impose such a rigid condition. Rather than an obligation to buy or sell, an option provides the right to buy or sell (depending on whether you are long or short).

Options fall into two categories.

Call options give the owner the right to buy an asset at a specified price (the strike price).

Put options give you the right to sell an asset at the strike price.

Strike price – The price at which an underlying security can be purchased or sold when trading a call or put option, respectively. A known price when an investor initiates the trade.

There’s a further important distinction between options and that is whether it is an ‘American-style’ or ‘European-style’ option. An ‘American style’ option allows the holder to exercise the option at any time up until its expiration date. A ‘European style’ option allows the holder to exercise only on the expiration date. Both styles of option are widely available regardless of geography.
Expiration date –the last day that derivative contracts, such as an option or future, are valid.

American and european style
Both call and put options are typically bought at a relatively small cost relative to the price of the assets involved. This cost is known as the premium. If the option is not exercised, the premium is lost. But because the premium is usually a relatively small cost, asset managers can establish large potential positions using options. If the market moves against the managers, the premium is all that they will lose. If the market moves in their favour, however, they can profit immediately by exercising the options.
Let’s say that you buy American-style call options for 10,000 shares in Erebus Plc at a strike price of £10 a share. That means that you can buy Erebus’s shares for £100,000 at any point during the life of the contract – three months, in this case. You pay a premium of £1 per share for this, which costs you £10,000. If the share price moves above £10, your option is ‘in the money’. If the share price rises to £12 before the end of the three-month period, you could exercise your option and buy £120,000 worth of shares for just £100,000. You have paid £10,000 for the option, so, if you sell the shares immediately after exercising your option, you will make a profit of £10,000.

Profit/loss for a buyer/holder of a call option – buyer expecting market to rise

Profit/loss for a buyer/holder of a call option – buyer expecting market to rise
Conversely, if the share price falls below £10 and fails to recover, your option is ‘out of the money’ and is worthless. But your losses are limited to the £10,000 premium you paid – a relatively modest amount compared with the value of the shares involved.
The largest risk from an option contract isn’t taken by the option holder (the party that buys the option) but by the option writer (the party that sells the option). If the option writer doesn’t own the assets covered by a call option, those assets will have to be bought on the open market if the option is exercised. As the price of those assets could, in theory, rise infinitely, the option writer is potentially exposed to very large losses.
An exception to this is if the option writer already owns the assets. In this case, the option writer is ‘covered’ in that the assets don’t have to be bought and any losses are on paper rather than out of pocket.
Essentially, an option writer always hopes that the option (whether call or put) will be ‘out of the money’ and will therefore expire without being exercised. In this case, the writer profits from the premium paid for the option.

4. Swaps

As the name suggests, swaps are a way of exchanging one series of cash flows for another. Swaps are most commonly used to allow two parties to exchange interest rates. That’s because the interest rates available to specific companies or institutions will vary according to how lenders assess the risks involved in making loans to them. By using swaps, those companies or institutions may be able to access interest rates that are more favourable to them.
Typically, swaps are constructed to exchange a fixed cash flow for a variable one. Those cash flows could be interest rates on loans, but they might also be the yields from other assets – for example, swapping the dividends in an equity portfolio for the coupons in a bond portfolio.
Swap agreements run for a specified period. They are over-the-counter contracts, which means that they are agreed to by the parties concerned and not traded on an exchange. Despite this, the swaps market is vast and highly liquid, so swap agreements are readily traded once established. Indeed, swaps make up the greater part of the global derivatives market.
Commonly, a financial institution acts a market-maker or intermediary for a swap agreement between two parties. This creates an opportunity for an intermediary – the swap bank – to allow two borrowers to exchange the cash flows that they are paying or receiving – to the benefit of both borrowers, who receive interest rates that are more favourable to their circumstances, and to the swap bank, which makes a profit in the process.

Profit/loss for a buyer/holder of a call option – buyer expecting market to rise

Physical settlement

The most straightforward type of settlement is physical settlement. This is simply when the asset in question is delivered by the settlement date.
So, if you are the short (the seller) in a futures contract that obliges you to deliver 10,000 bushels of wheat by 31 July 2026 for $10 a bushel, you must deliver that quantity of wheat to the long (the buyer) by the due date.
Cash settlement

Cash settlement of a contract means that no physical assets change hands. Instead, the ‘loser’ from the contract simply pays the difference in cash.
In the example above, let’s say that the price of wheat has risen to $12 a bushel by the settlement date. Rather than pay $120,000 for 10,000 bushels of wheat which are to be delivered to the long, the short pays the long the difference between the contract’s strike price and the current market price – which would be $20,000 in this case.
However, derivatives are time bound financial instruments. This means that they come with an expiration date. They have intrinsic worth only up till that date and post that date they are worthless. Expiration date is a term usually used when we refer to options in particular. When we talk about forwards, swaps or futures, the expiration date is replaced by the settlement date. However, the idea remains the same. Expiration date is when the contract is finally unwound and the profits and losses due become a reality. Simply put that is the end of the agreement.

So what have we learned

Derivatives are financial securities that derive their value from that of other assets. They were first developed to limit the losses and uncertainty caused by adverse conditions in agriculture. Today, derivatives form a huge market worth many trillions of dollars.
Some types of derivative can be bought ‘over the counter’ while others are traded on formal exchanges. Derivatives fall into four broad categories: forwards, futures, options and swaps. Some derivatives contracts must be settled through the delivery of the underlying goods, but many use cash settlement instead.
Derivatives can be used to gain exposure to movements in asset prices without the need to buy the underlying assets. Asset managers principally use them for hedging / EPM, asset allocation, income generation and leverage. The main risks of investing in derivatives stem from movements in the prices of the underlying assets. If these move further than one party to the derivatives contract thought probable, that party could incur substantial losses.
Graham Finlay
Graham Finlay
Strategic and Technical Sales Manager

Graham works within the Strategic & Technical team at Columbia Threadneedle Investments. Graham has undertaken a variety of adviser focused roles since 2003. Over the last few years he has been responsible for developing and delivering presentations at seminars across the UK on a broad range of investment and financial planning related topics. Graham holds a number of industry qualifications, including the CFA Certificate in ESG Investing, Investment Management Certificate (IMC), Diploma in Investment Management (ESG) and has more than 20 years’ industry experience. Graham previously worked with both Edinburgh Fund Managers and Scottish Widows.

Graham Finlay
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