Derivatives – ‘He who must not be named’

It was almost the same time when I started reading Harry Potter and also started trading in derivatives..It was way back in 2005, third year of my college. 4 years since then, the villain of the story - Voldermot is already dead and the derivatives market – He who must not be named in the financial parlance , has collapsed the entire financial system….Was there a fundamental problem with derivatives as a concept or was there a problem in the so called innovative products into the markets..Lots and Lots of debate goes around in the financial circle.This article will not get into all such debates..This is just a primer to the world of derivatives

There are lot of derivative instruments which are used to hedge risk. I’ll introduce the most prominent among them: Forwards & Futures, Options.

Forwards &Futures: Turn into the first page of any derivative book or type in Forwards and Futures in Google and the first example you would find is,
Assume a farmer who is planning to plant some crops and is planning to harvest in about three months. He is worried about the price fluctuations that can happen to the crop prices . Hence he would like to lock his price at the current market price. So he enters into a contract with a buyer promising him to sell at a particular rate.. This rate is called the forward rate. What determines the forward rate??

Let me try explaining forward through a cricket example.Assume if Dhoni price tag (as per his current form) in a IPL auction is 6 crore.This will be the spot price for Dhoni. Now assume there is a series in Newzealand and South Africa before the IPL begins.Now the team owners make a prediction that when Dhoni plays on such true pitches he loses his form and he would be in pathetic form before IPL. Hence his forward price would be less than 6 crore.So he would not buy Dhoni at 6 crore, but rather he will be willing to pay a price of less than 6 crore. And forward contract is just a promise to buy in the future and upfront payment is not made.
Why would somebody want to sell under a price less than the current price? Because you’ll not be able to sell everything in the spot market as in the case of a farmer..

Generally forward price = S*e^rt

This is nothing but the compound interest formula which we studied in our 6th class. This version of the formulae indicates that forward price should quote at a compounded value of the spot rate at the risk free interest rate (This does not take the market conditions I spoke about)
Futures is similar to forward, the only difference being it takes place with a lot of regulation and intermediation..Forward transactions will normally happen for avoiding a risk, but generally futures transaction will be on speculation (Of course, I have made a lot of over simplifying statements here!!)


Options:

I was looking for a house for rent when I was in Bangalore. I found a house through a broker for a rent of 8000 per month. I liked the house very much and the rent was also at very much affordable levels.But we wanted to search other houses as well.
Hence we didn’t want to shift to the new home immediately..We wanted to take a chance. We wanted to delay the option of shifting, as well as we wanted to have the option of getting into the new home. As the prices in Bangalore were skyrocketing at that period(hypothetical) , if we were to come three months later the rent would have been double what we had to pay currently . Hence we devised a strategy..We said to the owner that we’ll pay three months of token advance immediately and will occupy the home after three month at the current rent. Now the house owner (who had an exactly opposite view of ours) thought that prices will fall in the next three months , immediately agreed to our strategy and got the three months advance from us…
Now we had the right to take the rental option three months down the line at the current price. But luckily all four of us got into top rung B-schools and hence we didn’t need the house anymore. Hence we didn’t have to use our right and hence we lost our 3 months advance ….
This is all about options... Two parties have differing view about market..One perceives the market to go up and the other perceives it to go down.Both of them think the other person to be a fool. The person who takes the risk is called the option writer and he gets an income for taking the risk..The risk for him (in our case the house owner) is that the rentals can skyrocket in the next three months but he is bound to give it at a much lesser price for us. So in order to have that option we gave the advance, which in financial parlance is called as option premium.
As we saw with the above example, we four had the right to buy something …This option is called as a call option.Exactly opposite to this is an option to sell which is called as a put option.

PS:I would have ideally liked to cover swap also through this article, but I generally try to restrict my posts to less than 1000 words. I promise you a post on swap in the forthcoming days…
PPS: There have been quite a lot of simplifying assumptions behind my example...These are just for illustrative purposes and might slightly deviate from the actual technicalities involved in the concept. Hence I would request the financial purists to resist from quoting comments on my examples.