Understanding Derivatives (1/2)

In this lesson, you’re expected to learn about:
– the derivatives market
– options
– forwards

The Derivatives Market

What are Derivatives?
Derivatives are legal contracts that set the terms of a transaction that can be bought and sold as the current market price varies against the terms in the contract. Prices change a lot over time, which adds a degree of uncertainty and risk for those who produce or purchase large quantities of goods.

Derivatives were originally all about bringing price stability to products that can be volatile in their pricing over short periods of time.

By speculating on the changes in future prices, companies have the opportunity to buy and sell many derivatives contracts at a profit simply because of other people’s willingness to trade these contracts. As a result, derivatives have dramatically increased in popularity as a method of generating income.

You can purchase and then resell derivatives at a profit but the whole process involves many types of risks. Despite the pitfalls, when used responsibly, they can provide companies with a useful financial tool. Derivatives have become so popular that the global derivatives market is enormous, worth as much as one quadrillion US dollars.

The four most common types of derivatives are:

· Options
· Forwards
· Futures
· Swaps

In this lesson, we’ll focus on options and forwards.

[Optional] The 4 Basic Types of Derivatives
What are Options? 

Options are contracts that give the buyer the right to buy or sell a fixed number of goods at a predetermined price but they don’t oblige the buyer to do so.

The two primary types of options are:
– Put options: when purchased, put options give the holder of the option the right to sell a predetermined quantity of some asset at a predetermined price, called the strike price before a predetermined future date, known as the expiry date.
– Call options: work in a similar manner to put options except that they give the buyer the option to purchase those goods rather than sell them.

Exercising an Option 

When buyers decide to use the option to buy or sell goods, they exercise their option. When they decide not to use the option, they either let the option expire or, if possible, try to resell it.

Managing Risk 

Companies can use put and call options as tools for managing risk. When you buy a put option, your goal is to make sure that you can sell your goods for the best price possible.

For instance, the put option may say that you have 10 tons of wheat to sell at a strike price of $10,000. If the price goes down between the purchase of the put option and the expiry date, you exercise your option in order to sell the wheat for a higher price than the market is currently offering.

If, on the other hand, the price goes up, you let the option expire because you can sell the wheat for a higher price on the market.

Generating Revenue 

Options aren’t sold for free. The seller of the option generates revenue equal to the sale price of the option, giving the seller incentive to sell the options. However, the seller must use them carefully because risk is involved. The risk applies to call and put options – they both generate sales revenues but also oblige the seller to a future transaction that may not be in the seller’s best interest.

The seller of an option is planning to buy or sell the goods at the strike price anyway or betting that the buyer won’t exercise the option due to price conditions that are unfavorable for the buyer.

In the case where the seller sells options purely to generate revenue without any expectations of participating in an exchange at the strike price, that seller puts itself at a greater risk of losses or potential losses that aren’t otherwise recorded on standard financial reports, which can cause concern for investors as well as the company itself.

Valuing Options 

There are many mathematical models for estimating the value of an option. In this lesson, we’ll focus on one of the more popular valuation equations and see how it can be applied in an investing portfolio strategy.

To find the value of selling an option, simply use this equation:
Value of selling an option = P + X
where P = price of the option sold
X = value of the exchange to the seller (assume that X is always negative)

To find the value of buying an option:
Value of buying an option = X – P

[Optional] How Options Work
forward contract is an agreement between parties to perform a sale of a specific type of good in a predetermined quantity at a predetermined price and at a predetermined future date in the future.

Unlike an option, which gives the buyer or seller the right to participate in the transaction but doesn’t oblige them, forward contracts are legal obligations to perform the transaction on or before a specific date.

The good thing about forwards is that they’re highly customizable and can include any details or additional terms as long as all the relevant parties agree to those terms.

Forward contracts aren’t bought or sold in the same manner as many derivatives contracts. Instead, two or more parties develop a legal contract, sign into that contract and typically fulfil the contractual obligations themselves. So neither party purchases or sells the actual contract.

The terms of a contract between two parties typically includes the following:
– product
– quantity
– delivery price
– delivery date

Both parties in the contract must execute their part of the contract and the contract itself is likely to include penalties for non-delivery.

Managing Risk 

Companies and individuals enter into forward contracts to reduce the amount of price uncertainty and volatility involved with buying or selling goods. Forwards allow buyers and sellers to agree upon a price and quantity of goods to be exchanged.
– For buyers, this arrangement provides increased certainty that they get exactly the quantity they need, without competing with other buyers for the same pool of suppliers and guarantees that the price doesn’t increase by the time of the delivery date.

– For sellers, forwards ensure that they have a buyer for their products instead of risking being left with a surplus, and also guarantees that the price doesn’t drop suddenly before the delivery date.

Generating Revenue 

Generating revenue with forward contracts is more difficult than with most other forms of derivatives. Forward contracts are so customizable that they aren’t conducive to trading.

After all, finding another buyer who wants the exact same contract you created to fit your needs and those of the other party can be close to impossible.

Valuing Forwards 

The value of a forward contract depends on fluctuations in the market price of goods. The calculation of the value of a forward is based on the following two basic ideas:

– the current price of a forward contract needs to be equal to the market price of goods at the delivery date, plus the opportunity cost associated with not pursuing the next best opportunity.
– at the time of delivery, the value of the forward rate is equal to the delivery price minus the market price.

[Optional] Forward Contract
Check out this article to learn more:
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