7.1 Types of derivatives
6 min read•august 21, 2024
Derivatives are financial instruments that derive value from underlying assets, playing crucial roles in risk management and market strategies. They come in various forms, each with unique characteristics and applications in modern financial markets.
This topic explores the main types of derivatives: , , , and . Understanding their differences, uses, and accounting implications is essential for grasping how these instruments shape financial landscapes and risk management practices.
Definition of derivatives
- Financial instruments deriving value from underlying assets, indices, or entities
- Crucial components in modern financial markets and risk management strategies
- Play significant roles in , , and activities in Intermediate Financial Accounting
Key characteristics
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- Derive value from underlying assets (stocks, bonds, commodities, currencies)
- Require little or no initial investment compared to direct asset purchase
- occurs at a future date
- Can be used to transfer risk between parties
- Exhibit high leverage potential, amplifying gains and losses
Purpose and uses
- Hedge against potential financial risks (market, credit, interest rate)
- Speculate on price movements of underlying assets
- Arbitrage price discrepancies across different markets
- Enhance portfolio returns through strategic positioning
- Provide price discovery for underlying assets in efficient markets
Types of derivatives
Forward contracts
- Customized agreements to buy/sell an asset at a specific future date and price
- Traded (OTC) between two parties
- No standardization, allowing for tailored terms
- Settlement typically occurs at contract
- Used extensively in foreign exchange and commodity markets
Futures contracts
- Standardized traded on organized exchanges
- Require daily settlement (marking-to-market) to manage counterparty risk
- Highly liquid due to standardization and exchange-trading
- Commonly used in commodities, currencies, and stock indices
- Subject to regulatory oversight and margin requirements
Options
- Contracts granting the right, but not obligation, to buy (call) or sell (put) an asset
- Require payment of premium by option buyer to option seller
- Come in American (exercise anytime) and European (exercise at expiration) styles
- Used for hedging, income generation, and speculative strategies
- Offer non-linear payoff structures, limiting downside risk for buyers
Swaps
- Agreements to exchange cash flows based on different variables
- Typically involve periodic payments over the contract's life
- Often used to manage interest rate, currency, or commodity price risks
- Can be customized to meet specific needs of counterparties
- Commonly employed by corporations and financial institutions
Forward vs futures contracts
Similarities
- Both involve agreements to buy/sell assets at a future date for a predetermined price
- Used for hedging and speculative purposes in various markets
- Require no upfront premium payment (unlike options)
- Can result in delivery of the underlying asset at contract expiration
- Offer linear payoff structures based on price movements of underlying assets
Key differences
- Trading venue: Forwards trade OTC, futures on exchanges
- Standardization: Forwards customized, futures standardized
- Counterparty risk: Higher for forwards, lower for futures due to clearinghouse
- Settlement: Forwards at expiration, futures daily mark-to-market
- Regulation: Forwards lightly regulated, futures heavily regulated
- Liquidity: Forwards less liquid, futures highly liquid
Call vs put options
Rights and obligations
- Call options
- Buyer has right to buy underlying asset at strike price
- Seller obligated to sell if buyer exercises
- Put options
- Buyer has right to sell underlying asset at strike price
- Seller obligated to buy if buyer exercises
- Both types require premium payment from buyer to seller
- Options can be European (exercise at expiration) or American (exercise anytime)
Payoff structures
- Call options
- Profit potential unlimited as underlying asset price rises
- Maximum loss limited to premium paid for buyer
- Break-even point: strike price plus premium
- Put options
- Profit potential capped at strike price minus premium
- Maximum loss limited to premium paid for buyer
- Break-even point: strike price minus premium
- Both types offer non-linear payoffs, unlike forwards/futures
Common swap arrangements
Interest rate swaps
- Exchange fixed interest rate payments for floating rate payments
- Used to manage interest rate risk or speculate on rate movements
- Notional principal used for calculation purposes, not exchanged
- Common in corporate finance to align debt payments with cash flows
- Can involve same or different currencies (cross-currency )
Currency swaps
- Exchange principal and interest payments in different currencies
- Used to access foreign capital markets or hedge currency risk
- Involve exchange of notional principals at initiation and maturity
- Help companies match foreign currency assets with liabilities
- Can combine with interest rate swaps for complex risk management
Commodity swaps
- Exchange fixed price payments for floating price payments on commodities
- Used by producers and consumers to hedge against price volatility
- Common in energy markets (oil, natural gas) and agricultural products
- Can be cash-settled or involve physical delivery of commodities
- Help stabilize costs/revenues for businesses dependent on commodity prices
Accounting for derivatives
Recognition criteria
- Derivative contracts recognized as assets or liabilities on balance sheet
- Initial recognition at fair value, usually the transaction price
- Subsequent recognition based on changes in fair value
- Recognition timing depends on trade date vs settlement date accounting
- Special considerations for embedded derivatives in hybrid contracts
Measurement principles
- Fair value measurement required for most derivatives
- Changes in fair value recognized in profit/loss unless hedge accounting applied
- Valuation techniques include market approach, income approach, and cost approach
- Consideration of counterparty credit risk in fair value measurements
- Disclosure of fair value hierarchy levels (Level 1, 2, or 3) required
Hedge accounting basics
- Optional accounting treatment to align timing of hedged item and hedging instrument
- Three types: fair value hedges, cash flow hedges, and net investment hedges
- Requires formal designation and documentation of hedging relationship
- Effectiveness testing required to qualify for hedge accounting
- Special accounting treatment for of options and forward points
Risk management with derivatives
Hedging strategies
- Use derivatives to offset potential losses in underlying positions
- Common strategies include delta hedging, portfolio insurance, and immunization
- Dynamic hedging involves frequent rebalancing of derivative positions
- Cross-hedging used when perfect hedge instruments unavailable
- Basis risk consideration crucial in designing effective hedges
Speculation vs hedging
- Speculation aims to profit from anticipated market movements
- Hedging seeks to reduce or eliminate existing risk exposures
- Speculators provide liquidity and price discovery in derivative markets
- Hedgers transfer unwanted risks to parties more willing to bear them
- Regulatory treatment and accounting implications differ for each purpose
Derivative valuation methods
Black-Scholes model
- Widely used for European-style option pricing
- Assumes geometric Brownian motion for underlying asset prices
- Incorporates factors: stock price, strike price, time to expiration, volatility, risk-free rate
- Closed-form solution for call and prices
- Limited by assumptions of constant volatility and no dividends
Binomial option pricing
- Flexible model suitable for American and European options
- Uses discrete-time framework to model possible price paths
- Allows incorporation of dividends and early exercise decisions
- Can handle complex option features and underlying asset behaviors
- Computational intensity increases with number of time steps
Regulatory environment
IFRS vs US GAAP
- IFRS 9 and ASC 815 govern derivative accounting under respective frameworks
- Both require fair value accounting for most derivatives
- Differences in hedge accounting rules and effectiveness testing
- US GAAP more prescriptive, IFRS more principles-based approach
- Convergence efforts ongoing but differences remain in specific areas
Disclosure requirements
- Extensive disclosures required for derivative instruments and hedging activities
- Qualitative disclosures on risk management objectives and strategies
- Quantitative disclosures on fair values, notional amounts, and gains/losses
- Tabular format presentations often required for clarity
- Enhanced disclosures for credit derivatives and credit-risk-related contingent features
Derivative markets
Over-the-counter (OTC)
- Bilateral trading between counterparties without exchange intermediation
- Allows for customization of contract terms to meet specific needs
- Generally less regulated than markets
- Higher counterparty risk due to lack of central clearinghouse
- Dominated by large financial institutions and sophisticated investors
Exchange-traded derivatives
- Standardized contracts traded on organized exchanges
- Central clearinghouse acts as counterparty to all trades
- Higher liquidity and transparency compared to OTC markets
- Subject to strict regulatory oversight and margin requirements
- Accessible to a wider range of market participants, including retail investors
Key Terms to Review (24)
Arbitrage: Arbitrage is the practice of taking advantage of price differences in different markets for the same asset. This financial strategy allows traders to buy low in one market and sell high in another, generating a risk-free profit in the process. It plays a critical role in ensuring that prices remain consistent across different markets, leading to market efficiency.
Basel III: Basel III is a global regulatory framework established to strengthen the regulation, supervision, and risk management within the banking sector. It aims to enhance the resilience of banks during economic stress by setting higher capital requirements, introducing leverage ratios, and improving liquidity standards. This framework is significant in reducing the risk of bank failures and maintaining financial stability, particularly in relation to derivatives trading and other financial instruments.
Binomial model: The binomial model is a mathematical method used to price options by creating a discrete-time framework for evaluating the potential future movements in the price of an underlying asset. This model breaks down the time to expiration into a series of steps, allowing for multiple possible outcomes for the asset's price at each step. The flexibility of the binomial model makes it particularly useful for valuing American options, which can be exercised at any time before expiration.
Black-Scholes Model: The Black-Scholes Model is a mathematical model used to calculate the theoretical price of options, specifically European-style options, based on various factors such as the underlying asset's price, the strike price, time to expiration, risk-free interest rate, and volatility. This model revolutionized the trading of options by providing a systematic method for valuing stock options and warrants, which are financial instruments that give investors the right to buy or sell underlying assets at predetermined prices.
Call option: A call option is a financial derivative that gives the holder the right, but not the obligation, to buy a specified quantity of an underlying asset at a predetermined price (known as the strike price) within a specified time period. This type of option is often used by investors who expect the price of the underlying asset to rise, allowing them to purchase it at a lower price before the option expires.
Commodity swaps: Commodity swaps are financial derivatives that involve the exchange of cash flows related to the price of an underlying commodity over a specified period. These swaps allow parties to hedge against price fluctuations in commodities such as oil, natural gas, or agricultural products, making them a valuable tool for managing risk in volatile markets. By locking in prices or exchanging fixed for floating payments, participants can stabilize their cash flows and reduce uncertainty associated with commodity prices.
Currency swaps: Currency swaps are financial derivatives that allow two parties to exchange principal and interest payments in different currencies over a specified period of time. These agreements help entities manage their exposure to foreign currency fluctuations and can also provide access to more favorable interest rates in foreign markets. By facilitating currency conversion and interest rate management, currency swaps play an essential role in international finance and risk management strategies.
Dodd-Frank Act: The Dodd-Frank Act is a comprehensive financial reform legislation enacted in 2010 aimed at reducing risks in the financial system following the 2008 financial crisis. It established new regulatory measures and oversight for financial institutions, including stricter rules for derivatives trading, to enhance transparency and protect consumers.
Exchange-traded: Exchange-traded refers to financial instruments, particularly derivatives, that are traded on a regulated exchange rather than over-the-counter (OTC). This method of trading provides a transparent marketplace where prices are determined by supply and demand, enabling standardization of contract terms and increased liquidity for participants.
Expiration: Expiration refers to the date on which a derivative contract, such as options or futures, becomes void and can no longer be exercised. This date is crucial because it determines the time frame for which the holder of the derivative can exercise their rights or obligations, impacting investment strategies and risk management.
Forward contracts: Forward contracts are customized agreements between two parties to buy or sell an asset at a specified future date for a price that is agreed upon today. These contracts are often used to hedge against price fluctuations in various types of assets, including foreign currencies, which helps businesses manage their financial risk and improve cash flow stability.
Forwards: Forwards are customized financial contracts between two parties to buy or sell an asset at a specified price on a future date. They are used primarily for hedging risks and are an important type of derivative that allows companies to manage price fluctuations in commodities, currencies, or securities. The unique feature of forwards is their ability to be tailored to the specific needs of the parties involved, making them different from standardized derivatives like futures.
Futures: Futures are standardized financial contracts that obligate the buyer to purchase, and the seller to sell, a specific asset at a predetermined price on a specified future date. These contracts are traded on exchanges and are commonly used to hedge against price fluctuations in various markets, including commodities and financial instruments.
Futures contracts: Futures contracts are standardized agreements to buy or sell a specific asset at a predetermined price on a specified future date. These contracts are essential in managing risk, particularly in volatile markets, and play a crucial role in derivatives trading, risk management strategies, and hedging practices.
Hedging: Hedging is a risk management strategy used to offset potential losses in investments by taking an opposite position in a related asset. This technique helps investors protect themselves against unfavorable price movements, ensuring more stable financial outcomes. Hedging is commonly implemented through various derivatives, including options and futures, and can also involve embedded derivatives in financial instruments or managing exposure to foreign currencies.
Interest Rate Swaps: Interest rate swaps are financial derivatives in which two parties exchange interest payment obligations on a principal amount, usually to hedge against interest rate fluctuations. This financial agreement allows one party to pay a fixed interest rate while receiving a variable rate, or vice versa, effectively managing their exposure to interest rate risk. Interest rate swaps are vital tools in the management of financial risks and play a significant role in fair value hedges.
Intrinsic value: Intrinsic value refers to the actual worth of an asset, determined by its fundamental characteristics, rather than its current market price. It represents the true or inherent value based on underlying factors, such as cash flows or economic conditions, which can be particularly relevant for options, warrants, and various types of derivatives. Understanding intrinsic value helps in assessing whether an asset is undervalued or overvalued in the marketplace.
Options: Options are financial derivatives that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before or on a specified expiration date. They play a crucial role in risk management, allowing businesses to hedge against fluctuations in prices, interest rates, or foreign currency exchange rates.
Over-the-counter: Over-the-counter (OTC) refers to the trading of financial instruments, such as derivatives, directly between two parties without a centralized exchange or broker. This method of trading allows for greater flexibility in terms of contract specifications and pricing, which can be tailored to meet the unique needs of the parties involved. OTC transactions are common in markets for derivatives, as they facilitate customized agreements that are not available on standardized exchanges.
Put option: A put option is a financial contract that gives the holder the right, but not the obligation, to sell a specified amount of an underlying asset at a predetermined price, known as the strike price, within a specific time period. This type of derivative is commonly used as a hedge against declines in the price of the underlying asset or as a speculative investment to profit from price decreases.
Settlement: Settlement refers to the process of concluding a derivative contract, where the parties involved fulfill their contractual obligations, typically through cash payments or the transfer of financial instruments. This key term is crucial in understanding how various types of derivatives function, as it determines how gains or losses are realized, and how exposure to risk is managed between counterparties.
Speculation: Speculation refers to the practice of engaging in financial transactions that involve significant risk with the hope of making a profit based on future price movements. This activity often involves buying and selling assets, such as stocks, bonds, or derivatives, with the anticipation that their prices will rise or fall. Speculators typically take on higher risks in pursuit of potentially high rewards, making their activities a key component of market dynamics.
Swaps: Swaps are financial derivatives that involve the exchange of cash flows between two parties based on predetermined conditions. They are often used to hedge risks, such as interest rate changes or currency fluctuations, and can also be utilized for speculative purposes. The structure of swaps can vary widely, allowing for a range of applications in managing financial exposure.
Time value: Time value refers to the concept that money available today is worth more than the same amount in the future due to its potential earning capacity. This principle is fundamental in finance, particularly in understanding how the value of cash flows changes over time and is essential for valuing derivatives and other financial instruments.