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Futures, options and swaps

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Derivatives

In finance, a derivative is a financial instrument (or, more simply, an agreement between two parties) that has a value, based on the expected future price movements of the asset to which it is linked—called the underlying— such as a share or a currency. Derivatives are tools for transferring risk.

Hedge is making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract. An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations. Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge).

Futures, options and other derivatives exist in order that companies and individuals may attempt to diminish the effects of losses from, future changes in commodity and asset prices, exchange rates, interest rates, and so on. For example, the prices of foodstuffs such as wheat, maize, cocoa, coffee, tea and orange juice are frequently affected by droughts, floods and other extreme weather conditions. Consequently, many producers and buyers of raw materials want to hedge, in order to guarantee next sessions prices. When commodity price are expected to rise, future prices are obviously higher than (at a premium on) spot prices, when they are expected to fall they are at a discount on spot prices.

In recent years, especially since financial deregulation, exchange rates and interest rates have also fluctuated wildly. Many businesses, therefore, want to buy or sell currencies at a guaranteed future price. Speculators, anticipating currency appreciations or depreciations, or interest rate movements, are also active in currency future markets, such as the London International Financial Future Exchange (LIFFE, pronounced ‘life’).

(There are many kinds of derivatives, with the most common being futures, options and swaps.)

Futures

Every weekday, enormous amounts of commodities, currencies and financial securities are traded for immediate delivery at their current price on spot markets. Yet there are also futures markets on which contracts can be made to buy and sell commodities, currencies and various financial assets, at a future date (e.g. three, six or nine months ahead), but with the price fixed at the time of the deal. Futures/Forwards are contracts to buy or sell an asset on or before a future date at a price specified today. A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold, whereas a forward contract is a non-standardized contract written by the parties themselves.

Options

Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike or exercise price, and is specified at the time the parties enter into the option. A call option gives the right to buy securities (or a currency, or a commodity) at a certain price during a certain period of time. A put option gives the right to sell an asset at a certain price during a certain period of time. These options allow organizations to hedge their equity investments.

 

The option contract also specifies a maturity date. In the case of a European option, the owner has the right to require the sale to take place on (but not before) the maturity date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity date. If the owner of the contract exercises this right, the counter-party has the obligation to carry out the transaction

 

 

On the contrary, if you expect the value of a share that you own to fall below its current price of 100, you can buy a put option at 100 (or higher): if the price falls, you can still sell your shares at this price. Alternatively, you could write a call option giving someone else the right to buy the share at 100: if the market price of the underlying security remains below the option’s exercise price or strike price, no one will take up the option and you can earn the premium.

Swaps

Options are merely one type of derivative instrument, based on another underlying price. Many companies nowadays also arrange currency swaps and interest rate swaps with other companies or financial institutions. Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets.

For example, a French company that can borrow francs at a preferential rate, but which also will need yen, can arrange a swap with a Japanese company in the opposite position. Such currency swaps, designed to achieve interest rate savings, are of course open to the risk of exchange rate fluctuations. A company with a lot of fixed interest debt might choose to exchange some of it for another company’s floating rate loans. Whether they save or lose money will depend on the movement of interest rates.

 


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