Derivatives

  • Headlines
  • News
    A detailed presentation of the main concepts relating to interest rate risk.
    March 14, 2019
    Market risk is the risk of loss related to changes in the market value of a portfolio of financial instruments.
    February 11, 2019
    Credit Rating Agencies are private companies whose main activity is to assess the ability of debt issuers to meet their financial commitments.
    January 23, 2019
    Corporate actions refer to events that occur in the life of a security: dividend payment, capital increase, takeover bid...
    December 21, 2018

Definition

To define in the simplest possible way a derivative, it will be said that it is an instrument whose valuation depends on (derives from) the value of another instrument, which is then called the underlying asset.

The parties trading a derivative actually negotiate the terms of a contract that will determine the financial flows resulting from the transaction, based primarily on changes in the value of the underlying asset(s). The underlying asset is not physically traded. This exchange may be optional (in the case of options), deferred (futures or forward contracts) or never take place (interest rate swaps).

Derivatives are available for all classes of marketable assets and the associated risks: interest rate risk, foreign exchange risk, capital risk, commodities risk and credit risk.

Since a derivative instrument corresponds to a bank's commitment, it is recorded at its notional value as an off-balance sheet item. However, the profit or loss resulting from the variation of the contract's market value is recorded in the balance sheet, as are, of course the financial flows generated by the contract when they become effective.

Usage

All derivatives can be used in one of three contexts: hedging, speculation and arbitrage.

Hedging: An actor who owns or intends to acquire the underlying instrument may take a position on a derivative in order to hedge against fluctuations in the price of the underlying. This strategy limits the losses incurred in the event of adverse price fluctuation, but in return generally implies giving up part of the potential gains from holding the underlying asset, somewhat on the same principle as insurance.

Speculation: An actor who anticipates a change in the price of the underlying may take a position on a derivative instrument. Derivatives generally allow you to take a position on a large notional amount, but with a relatively low initial investment. This is called leverage. In this case, the prospects of profit are important if the strategy proves successful, but the losses can be just as important.

Arbitrage: An actor detects an inconsistency between the market value of a derivative instrument and that of the underlying. It then simultaneously takes up a counter position on the spot market of the underlying and on the derivative instrument. This type of strategy allows minimal gains on each transaction, but without risk. It must be implemented systematically in order to generate significant profits.

Arbitrage has a beneficial effect on markets by eliminating inconsistencies, which makes the price discovery process more efficient. Speculation brings liquidity to the markets and thus makes it easier for hedgers to find a counterparty to hedge.

Over-the-counter and listed derivatives

Derivatives can be traded either on organised markets (exchange-rated or listed derivatives) or over-the-counter (OTC derivatives). Increasingly, under pressure from regulators, market participants also have the possibility - and indeed the obligation under the EMIR Directive in Europe - to go through a clearing house for the settlement of their OTC derivative transactions. The table below summarises the characteristics of the different markets.

Listed derivative Cleared OTC derivative OTC derivative

Standardised

Standardised

Adapted to customer needs

Traded on an organised market

Bilaterally negotiated

Bilaterally negotiated

The parties do not know each other; the clearing house assumes the counterparty risk.

The parties know each other during trading but then the clearing house replaces them to assume the counterparty risk.

The parties know each other and assume counterparty risk. The master agreement often includes an appendix defining collateral exchanges (CSA, Credit Support Annex).

Plain vanilla products and complex products

The expression "Plain Vanilla" refers to basic derivatives traded on organised or OTC markets, but whose characteristics do not include any variant with regards to the definition of the product. In contrast, complex or exotic products are adapted to the specific requirements of a customer.

Note: the expression also applies outside the context of derivatives. For example, a plain vanilla bond as opposed to a convertible bond.

Typology of derivative instruments

According to J. Hull, a reference on the subject (see below), derivatives can be classified into four major families according to the terms of the contract.

A forward contract means that the exchange of the underlying is delayed over time. This is the case of forex forwards or FRAs (Forward Rate Agreements). Forward contracts are traded over-the-counter (OTC).

A future contract also involves a time-shifted exchange, but this time the contract is standardised and traded on an organised market. It can then be easily resold before maturity, thus avoiding the need to deliver or receive the underlying.

An option contract gives the buyer the right, but not the obligation, to buy or sell the underlying at a future date at an agreed price. Options may be traded over-the-counter or on organised markets.

Finally, swap contracts involve the exchange of two underlyings, as in the forex swap, or income associated with two underlyings, as in the interest rate swap or the asset swaps.

On the Web

The reference book is "Future Options and Other Derivative Assets", by John Hull. For the not so brave ones (it is a massive book!), the slides of John Hull's courses at the University of Toronto can be downloaded here.