A Quick Whizz Through Derivatives

Here, we discuss derivatives and their main types. This is useful reading for those who are preparing to sit any of the CII R02, J10 or AF4 exams.

This article is correct as at 25 June 2024.

Derivatives are financial contracts whose value is based on, or “derived” from, an underlying traditional security, asset or market index (often referred to as “the underlying”). Their use can be traced back to agricultural markets in the 19^th century when farmers wanted to secure a price for their produce ahead of its being harvested – a simple forward contract. Nowadays, they are used extensively in financial markets both for conventional purposes and as part of more complex products and are an area that many students find tricky. We’ve tried to come up with mnemonics (in brackets) after the most commonly used terminology as an aide-memoire.

The main types of derivatives are futures, options and swaps.

Futures

Futures contracts give one party the right to buy and the other party the right to sell a fixed amount of an asset at a fixed price on a fixed date. The buyer of the future is said to be long – committed to buying the underlying (long goodbye?). The seller of the future is short – committed to selling the underlying (sold short?). Most futures contracts don’t end up being delivered – they are “closed out” by making a closing sale before maturity. The contract itself has a value and financial futures are normally entered into for speculative purposes rather than because the buyer wants to take delivery of the underlying. Commodity futures will tend to be settled physically – back to those farmers selling their crops.

Options

Options give the buyer the right, but not the obligation, to buy or sell a fixed amount of an underlying at a fixed price, on or before a fixed date. Call options give the buyer of the contract the right to buy (please call by!) and Put options give the buyer of the contract the right to sell (PS). The seller or writer, in exchange for a premium, grants the option to the buyer or holder. Most financial options are cash settled rather than physically settled – there are a range of possible outcomes for writers and holders depending on price movements of the underlying.

Holder of call – the more a price rises, the higher the profit as can buy under value

Writer of call – receives a premium and hopes the price doesn’t rise or may be forced to sell under value

Holder of put – the more a price falls, the higher the profit as can sell over value

Writer of put – receives a premium and hopes prices don’t fall or may be forced to buy over value

Swaps

Swaps are an agreement between two parties to exchange a series of cash flows over a period of time – for example an interest rate swap, where one party exchanges floating rates of interest for fixed rates

Very few private investors buy derivatives directly, but many financial products now use them as a matter of course. Structured products (often marketed as capital protected) will almost inevitably use derivatives to achieve their aims. Managers of collective investment schemes use derivatives for a range of purposes, including asset allocation, currency and interest rate plays, and capturing volatility, and may also look to increase their income by writing options based on their underlying holdings.

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