Derivatives Explained

All of your derivative inquires answered

Derivatives are financial securities whose value is derived from another "underlying" financial security

Examples of derivatives include:

Options Futures Swaps

Swaptions
Structured notes

Derivatives can be used for hedging, protecting against financial risk, or can be used to speculate on the movement of commodity or security prices, interest rates or the levels of financial indices

Some derivatives are compared to insurance. Just as you pay an insurance company a premium in order to obtain some protection against a specific event, there are derivative products that have a payoff contingent upon the occurrence of some event for which you must pay a premium in advance

The valuation of derivatives makes use of the statistical mathematics of uncertainty, which is very complex

The value of a derivative is never predetermined. It is derived from the underlying factors such as asset, index, or interest rate

There are two main types of derivatives:

Linear
Non-linear

A linear derivative is one whose payoff is a linear function. For example, a futures contract has a linear payoff in that every one-tick movement translates directly into a specific dollar value per contract.

A non-linear derivative is one whose payoff changes with time and space.

With non-linear derivatives it is possible to capture gains from volatility by hedging a portion of the option's value.

This is called the "delta" given by a mathematical formula derived from the formula used to determine price, and rebalancing the hedge as spot moves around and the delta changes

The more times we can deltahedge the option, the more profit we will realize!

Every time you realize a profit, you help to pay for the option. If you own an option and you delta hedge it, you will:

make money if the stock price goes up make money if the stock price goes down

At the end of the day, you will only make money if you have realized delta-hedging profits that are greater than the premium you paid away for the option

Option Pricing

Buy an option
arguing that we will make more money dynamically hedging around it than we will pay in premium

Sell an Option
arguing that we will make more money in premium than we will lose in dynamically hedging the option

One of the prime determinants of the price of an option is the volatility

Volatility
The measure of how much the spot rate is expected to move around
high volatility environment: the spot rate will be expected to move around aggressively and options premiums are very high low volatility environment: the spot rate is expected to move around very little and options premiums are very low

Two characteristics of volatility:

volatility is not constant; it changes over time

volatility is statistically persistent; it trends

Credit risk is a significant element of the galaxy of risks facing the derivatives dealer and the derivatives end-user

Risk of Default
Most obvious form of risk Default means that the counterparty to which one is exposed will cease to make payments on obligations into which it has entered because it is unable to make such payments This is the worst case credit event that can take place

For more financial education regarding derivatives, visit www.finpipe.com