Financial Derivatives: The Basics

Recently, financial instruments known as derivatives have become ubiquitous.  As such, this post sets forth basic information necessary to understand these exotic financial instruments. 

The term financial derivative refers to a (1) contractual arrangement between two or more parties (2) that specifies the terms of a future transaction, (3) which ultimately derives value from an underlying asset or metric (“underlying”).  As with all trades, a financial derivative requires both a buyer (i.e., long position) and a seller (i.e., short position).  Generally, one party’s loss results in an equal gain to the counterparty, and vice versa.  Notably, derivative products can lead to highly leveraged balance sheets and financial markets because investors do not have to own the derivative’s underlying asset.  Thus, not surprisingly, many types of these securities exist, both bespoke (i.e., privately negotiated) and standardized.  They can exist both on regulated exchanges (e.g., equity options markets) and in over-the-counter markets (e.g., credit default swaps).  Basic financial derivatives include the forward, the option, and the swap. 

A forward is a financial instrument that obligates the seller to deliver an underlying asset to the buyer on a specified date at a predetermined price.  For example, assume S agrees to sell 100 barrels of oil to B one month from today at $90 per barrel.  If on the future date, the market price of oil is $95 per barrel, S must nonetheless sell 100 barrels of oil to B at $90 per barrel.  This results in a loss of $5 per barrel to S (because otherwise S could have sold the same 1,000 barrels of oil on the open market for $95 per barrel) and a $5 per barrel gain to B (because otherwise B would have to purchase the same 1,000 barrels of oil on the open market for $95 per barrel).  Commonly, however, these transactions are cash settled, so buyers and sellers do not actually deliver the underlying asset.  Rather, they exchange cash payments equal to their respective gains and losses.  This instrument is commonly employed for, among other reasons, speculation on commodity prices, or to hedge against devaluing inventories.   

Next, an option gives a buyer the right, but not an obligation, to purchase an underlying asset from the seller on a specified future date at a predetermined price (commonly referred to as the strike price).  The seller is required to deliver the underlying asset only if the buyer exercises the option.  Buyers pay the seller a premium for the option; the seller keeps the premium regardless of whether the buyer exercises, and thus, benefits from the option.  To illustrate, assume the same facts as above except now B has an option to purchase oil from S.  If one month from today the market price of oil is $95 per barrel, B will exercise the option requiring S to sell 1,000 barrels of oil to B at $90 per barrel.  The same financial gain and losses as above result to S and B, respectively, less the premium.  Different from the future contract, however, if the market price of oil is $85 on the future date, B is not obligated to purchase the oil from S.  B would let the option expire, purchase the oil on the open market at the lower price of $85 per barrel, and S would keep its premium.  Market participants use options to both speculate and hedge.

Finally, a swap is a contract under which one party receives a series of variable payments, determined by reference to an underlying metric, in exchange for making a series of fixed payments.  Thus, each party gains or losses depending on whether the fixed payments exceed the variable payments or vice versa.  For example, assume F makes payments under a variable interests rate note (i.e., the interest rate under the note may increase from time to time).  F would like to ensure the note’s interest rate does not increase.  As such, F agrees to make a series of fixed payments to V in exchange for V’s promise to pay F any amount above the current interest rate of the note, should the rate increase.  If the note’s interest rate never increases, V profits from F’s fixed payments.  On the other hand, if the interest rate increases, V must pay F, likely resulting in losses to V.  Thus, swaps also provide parties with hedging or speculative abilities.  Commonly, institutions use swaps to manage interest rate risk, or to speculate in a similar manner.