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What is derivative?

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    Benton Li
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Foreword: This is not the derivative you learned from freshman Calculus (or Calc BC you took in 8th grade who cares lmao)

By name, it is something derived from another.

In finance, it's a contract whose value is derived from things like indexes, stock prices, interest rates, etc.

Usually, it has 2 types:

  • Forward/future (the difference will be explained later)
  • Option

Sometimes we treat swap as a derivative too. (explained later)

Forward/future

  • In traditional transactions like buying McNuggets, the settlement takes place immediately - you pay and get nuggets right away. In contrast, a forward/future contract is settled in the future.
  • Forward and future are twins. Although they are both like “bets” for the future, they are different in the following ways:
    • Forwards are traded over-the-counter (OTC) and the futures are traded at the Exchange.
    • Future trades require a margin account at the Exchange and daily settlement whereas forwards don’t
    • Futures are more regulated than forwards but in recent years the regulation of the latter tends to be stricter
    • They have quite different valuation methods.
  • Holding a future contract means you have the obligation to pay for an asset at a specified price/rate on a future date.
  • A simple analogy is that you pay a deposit to your landlord so you can rent the house at the specified rate.
  • See future for more

Option

  • An option gives you the right, but not an obligation, to buy/sell an asset at a specified price/rate on a future date.
  • But after the option expires, you lose the privilege to buy/sell at that price
  • A simple analogy is that you buy an OurBus SuperPass to have the option to buy a discounted ticket.
  • Click here for more

Swap

  • A contract that you and the opponent periodically exchange cash flow.
  • It is conceptually a series of successive cash-settled forward
  • It’s not sometimes considered a derivative as its value is not derived from any underlying assets. Nothing will be sold/bought
  • Click here for more

Usage of derivatives

  • Hedging
  • Arbitrage
  • Speculation: You don’t have to own a stock yet you can access the price and economy of the underlying asset.

Types of Settlement

  • Cash settlement: “Just take the f**king money” — William Shakespeare. Common in interest rate derivatives and equity index derivatives
  • Physical settlement. Common in for derivatives traded at Exchange

Advanced Reading

Exchange vs. OTC

Exchange is more regulated, ofc, for the sake of liquidity. Its features include:

  • Fixed tick size
  • Standardized lots and units (e.g. 1 gold futures controls 100 troy oz)

However, there are things you can’t do at Exchange.

  • e.g. Curb trading is a no-no.
  • e.g. Crossing is restricted

OTC is more flexible and bespoke. However, Dodd-Frank Act puts more regulation on the derivative OTC market, particularly on the swaps market. Now OTC markets are more or less centralized electronic market venues. They too need to file mandatory reporting and they centralize clearing, collateralization, and margining through CCP.

Notice that this post is just a generic description. Derivatives may have different meanings in different contexts. They can be more than options and futures.

Examples:

  • Fixed income + derivative → cap, floor, caplet, floorlet…
  • Equity + derivative → call, put
  • Credit + derivative → CDS, CDO, CLN, …

You can also play derivatives in different combinations.

Examples:

  • Certain call + certain put → synthesized forward
  • long certain cap + short certain floor → a risk-free collar
  • Bermudan swaption + interest rate swap → a cancelable swap