Oh, Derivative! Who art thou? (or an Introduction to Derivatives)

Finance has been jargonized so much that people with non-financial background often find themselves asking the same question over and over again

“…but what does it mean?”

Does this sound familiar? Do financial concepts often make you feel that it is too complicated and is not your cup of tea? I have had my fair share of personal experiences and learnings in finance. Often after understanding a concept, I wonder, if only it were explained more simply I would have mastered it much faster and with a more intuitive understanding. I, therefore, try to keep things simple so that anybody with little/no background in finance can understand these concepts easily.

Today we will discuss about derivatives. It is a relatively advanced topic in finance, and if you have heard about it before and found it confusing or complicated, I assure you by the end of this article your perception will change.

Cutting through the chase, let’s look at the definition of a derivative.

What is a derivative?

To explain, a derivative is a contract between two parties that allows them to buy or sell an asset/s at a future date at an agreed-upon price. The derivative “derives” its value from the underlying asset whose buying/selling it enables.

Why do derivatives exist?

Derivatives make it possible to transfer the future risk of the underlying asset to the party willing to undertake it. The ingenuity of derivatives comes from the fact that they are designed in such a way that you do not need the actual transfer of the underlying asset to transfer the risk. Also, typically you need to pay a fraction of the total price of the underlying asset to assume the risk and of course returns.

Let me further simplify. The risk of an asset belongs to its owner. In case, the owner wants to mitigate the risk on his assets he can do so by the use of derivatives. This whole act of risk mitigation is called hedging and derivatives were initially invented to be an instrument that makes hedging possible. Following example will demonstrate how hedging is achieved using the derivatives:

Practical use of derivative

Assume that you are the CEO of a tyre manufacturing company “NRF”. NRF is a well-established company and is listed on the stock exchange. As the CEO of “NRF” you need to create value for your shareholders. To do that, you need to ensure that the profit of the company is stable and does not fluctuate too much across quarters. This is not an easy task as there are several variables related to demand and supply that keeps on changing with time.

Coming to the current affair of things, you believe that the cost of the natural rubber (main raw material of tyres) is going to fall and consequently the cost of the tyres will come down. The business in the last quarter was good. NRF was profitable, and it is your job to maintain similar profitability in the next quarter as well. One of your major customers is a huge automotive manufacturer “Naruti”. The management of Naruti wants to stabilize their input costs so that they can do better financial planning for their vehicles. Naruti needs to safeguard their operating margin, and they would want to lock-in the raw material costs at a particular price point. Their main concern with NRF is that the cost of their tyres might go up in the future and that can adversely impact their profit margin.

Both NRF and Naruti would want stability in their cash flow and profit margins. Also, to succeed NRF would want their sales numbers stable and Naruti would want the input costs stable. However, most importantly, NRF’s management thinks that the costs of the tyre might come down in the future, and Naruti’s management believes that the tyre prices will go up.

This is a perfect setting for the use of derivatives. To mitigate the risks for both NRF and Naruti, they will sign a forward contract (a type of derivative) today which fixes the price and quantity of tyres that NRF will supply to Naruti at a future date.

Let’s put in the numbers to see the implication of signing such a forward contract:

Today’s tyre price is Rs. 1000 per tyre. The forward contract signed between NRF and Naruti says that NRF will supply 10,000 tyres at the price of Rs.1000 on 1st Jan 2019 to Naruti.

The market price of the tyres on 1st Jan 2019 will determine whether NRF of Naruti will end up in profit. In the table below have taken three scenarios of profit and loss for Naruti and NRF.

Practical use derivative

Remember, the key thing for any derivative to work is that there must be two parties of opposing viewpoints. In this case, NRF believes that the tyre prices will come down and Naruti believes that the tyre prices will go up. Irrespective of whatever happens in the future, both find it in their best interest today to use a derivative and “hedge” for the future.

The example that I showed today is a typical forwards contract. This type of derivative is not the one that is traded in the stock exchanges. Forwards contracts are typically made between two parties and are usually not meant for trading. The tradeable forwards contracts are called futures. They are essentially the same as the forwards contracts just that they are standardized and traded in exchanges. Talk about using one name too many for the same thing!

What are the benefits of Derivatives?

The benefits of derivatives are highlighted below

  • They make an effective instrument of “hedging” as described in the example above
  • Derivatives require minimal investment compared to the quantum of resources they control
  • Investors and speculators can trade in derivatives to make leverage gains
  • Derivatives offer a low transaction cost alternative to investing directly in assets
  • Derivatives increase the growth pace by stabilizing the finances of companies
  • Derivatives can be custom made for any specific need

What is the dark side of derivatives?

Derivatives are widely and wildly used in the financial world. In fact, rampant unregulated use of derivatives was at the crux of 2008 financial crisis. Collateralized Debt Obligations, Mortgage-backed Securities were a few types of derivatives that were used recklessly by profit greedy banks to create a crisis. It nearly brought the world economy to a state of collapse.

Coming closer to an individual level, the derivatives have resulted in massive losses to many traders. As derivatives are highly leveraged financial instruments, they can potentially wipe out the entire capital of the trader playing with it. It often does.

If you want to embark on this fascinating journey of derivatives, you can join the webinar on “Quintessential Derivatives: 1-Hour Roller-coaster Ride on Futures, Forwards, Options and Swaps” by Mr. Amit Parakh powered by Learno. Mr. Parakh is among the highly qualified global trainers in the financial training space. He has a B-Com from Calcutta University and an MBA from IIM Ahmedabad. He has aced Chartered Accountancy, FRM, CS, CFA® exams all in the first attempt and has mentored thousands of students in their careers in finance.

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