This week we are going to consider derivatives.
These are mainly traded in developed and stable economies and in Zimbabwe trades have been restricted to equity ca
ll options and equity margin accounts which can be described as an adjusted futures contract only. This article aims to give the investor a general understanding of what derivatives are and how they operate.
A derivative can simply be defined as a financial contract/security whose value/price depends upon that of an underlying asset. Thus the value of the contract is derived from that of the underlying asset. Derivatives can be used for two main purposes – as a hedge against price fluctuations and for speculative purposes. Examples of derivatives contracts are forward, futures, options and swap contracts.
Forward contract – under this contract, two parties – buyer and seller agree to trade on a specified asset at a future date. The details of the agreement will include asset price, the quality of asset to be traded (in case of commodities), the date and time of trade as well as the place where the asset would be delivered to.
The contract carries with it the obligation to go through the agreed transaction from both parties. It should be noted that there would be no exchange of money up until the exercise date when payment would be made upon delivery of asset.
For example, consider the portfolio diversification problem facing a farmer growing a single crop like wheat. The entire planting season’s revenue depends critically on the highly-volatile crop price. The farmer cannot easily diversify his position because virtually his entire wealth is tied up in the crop.
On the other hand the miller who must purchase wheat for processing faces a portfolio problem that is the mirror image of the farmer’s. He is subjected to profit uncertainty, because of the unpredictable future costs of the wheat. Both parties can reduce this source of risk if they enter into a contract requiring the farmer to deliver the wheat when harvested at a price agreed upon now, regardless of the market price at harvest times.
Futures contract – futures contracts formalise and standardise forward contracting. In this instance buyers and sellers do not have to depend on a chance to match of their interests. They can trade in a centralised futures market. The futures exchange also standardise the types of contracts that may be traded by establishing contracts sizes, acceptable grade of commodity, contract delivery dates and the price of the commodity.
While standardisation eliminates much of the flexibility available in forward contracting, it has the offsetting advantage of liquidity because many traders will concentrate on the small set of contracts available. The standardisation of contracts and the date of trading in each contract allow futures positions to be liquidated easily through a broker rather than personally renegotiating with the other party to the contract. Because the exchange guarantees the performance of each party to the contract, costly credit checks on other traders are not necessary. Instead, each trader simply posts a good faith deposit called the margin in order to guarantee contract performance. Futures differ from the forward also in that they call for a daily settling up of any gains or losses on the contract.
Options contract – these can either be call or put option contracts. An option contract can be defined as a contract that conveys to its holder the right but not the obligation to buy (call) or sell (put) an asset of the underlying security at a specified price (called strike price) on or before some specified expiration date. The seller of an option contract is in turn obliged to sell (in case of call) or buy (put) the asset to (from) the buyer/holder of the option contract at the exercise price in case of the buyer exercising.
For example: an August 31 two months maturity call option on XYZ stock with an exercise price of $75 per share is sold on June 30 for a premium of $10. Up until the expiration date the holder/buyer of the call is entitled to buy XYZ shares for $75 each. On date of purchase the share was selling at $70. If the share price remains below $75 then the call will expire worthless and the investor will lose the $10 paid initially. If on the other hand the share sells at $100 at the expiration date, the option will turn out to be profitable.
Swap contract – this is a contract (agreement) between two parties to exchange cash flows at some future date according to a prearranged formula. In a classic swap contract, the value of the contract at that time it has been entered into as well as at the end of its life is zero. The two most popular kinds of swaps agreements are interest rate swaps and cross currency swaps.
In an interest rate swap arrangement two parties – one receiving a fixed interest rate and the other a floating rate, may agree to exchange their assets in the future. This may be necessitated by the nature of their liabilities in the future and through swapping they will be trying to match their assets against their liabilities.
When properly structured, derivatives can offer returns that are above the traditional investment vehicles and are thus worthy to be part of an investor’s portfolio.
In order to provide balanced information to the market, next week we will look at the fund manager by exploring the different portfolio management strategies that a fund manager can adopt.
*This article has been prepared by Imperial Asset Management (Pvt) Ltd.