Chapter 1

… Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated. The term “risk,” as loosely used in everyday speech and in economic discussion, really covers two things which, functionally at least, in their causal relations to the phenomena of economic organization, are categorically different. … The essential fact is that “risk” means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomenon depending on which of the two is really present and operating. … It will appear that a measurable uncertainty, or “risk” proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all. We … accordingly restrict the term “uncertainty” to cases of the non-quantitive type. – Frank Knight, Risk, Uncertainty, and Profit, 1921.

I. INTRODUCTION

Derivatives are contractual agreements between two parties – buyer on one side, seller on the other side – to buy and sell the real or financial assets on a future date at a specified price. In other words, the contract is negotiated today, but actual transaction of the assets takes place on future date. In contrast, in the spot market such transaction takes place immediately for cash. The financial assets are stocks, bonds, currencies. The real assets are commodities like crude oil, wheat, cattle etc.

In a way derivatives market is different from spot market, but they are inter-linked. In fact, these contractual agreements are called derivatives in the sense that their values are ‘derived’ from the prices of the assets traded in the spot market. In a derivative contract we call these assets the reference assets or underlying.

Derivatives are contractual agreements between two parties to buy and sell the real or financial assets on a future date at a specified price.

Financial assets: stocks, bond, currencies.
Real assets: crude oil, wheat, cattle.

 

Q. Why does someone want to buy or sell on a future date when they can do so in spot market?

For example, you are holding some shares of a firm. You would gain from the shares if you can sell them at a higher price, which is known to us as capital gain. However, future prices are unknown to us. If the stock price goes down, you would face losses. The risk of losing money can be prevented if you negotiate a price now to sell the shares. Such contractual agreement gives you the guarantee to sell shares at the negotiated price rather than at the market price even if the price goes down substantially.

Take another example. If you want to buy something in future your main concern is whether price of the item would go up in future. If you think so, then the best way to avoid paying high price is to negotiate a contract now to buy on a future date at a certain price fixed today. Such contractual agreement gives you the guarantee to buy the item at the negotiated price rather than at the market price even if the price goes up substantially.

Any derivative contract gives you the guarantee to sell (buy) shares at the negotiated price rather than at the market price even if the price goes down (up) substantially.

II. Long and short positions

In every derivative contract, one party is the buyer and the counterparty is the seller. The position of the buyer is said to be long, and the position of the counterparty is said to be short. Both parties negotiate a price of an underlying asset for a future date when the party in long position pay the negotiated price in exchange of the asset from the party who is short position.

Types of derivatives instruments

While there are thousands of assets in the spot market, the contractual agreements written on them are of few types, which are derivative financial instruments. These instruments are, in general, categorized into four groups:

  • Forwards
  • Futures
  • Swaps
  • Options

Both forwards and futures have a lot of similarities, but there are differences the way they are traded. Swaps can be expressed as a portfolio of forwards. Options care distinctly different from the other contracts. While forwards, futures and swaps are linear derivatives instruments, options are nonlinear ones.

Category: Introduction

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- July 24, 2017

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