Derivatives: options,warrants. Derivatives Categorization of derivatives Uses of derivatives Types of derivatives Valuation Options Warrants
Derivatives A derivative is a financial instrument - or more simply, an agreement between two people or two parties - that has a value determined by the price of something else (called the underlying). It is a financial contract with a value linked to the expected future price movements of the asset it is linked to - such as a share or a currency. There are many kinds of derivatives, with the most notable being swaps, futures, and options. Referring to derivatives as stand-alone assets would be a misconception, since a derivative is incapable of having value of its own. However, some more commonplace derivatives, such as swaps, futures, and options, (which have a theoretical face value that can be calculated using formulas, such as Black- Scholes), have been traded on markets before their expiration date as if they were assets. Amongst the earlier derivatives, rice futures have been traded on the Dojima Rice Exchange since 1710
Uses of derivatives Derivatives are used by investors to provide leverage or gearing, such that a small movement in the underlying value can cause a large difference in the value of the derivative speculate and to make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level) hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out obtain exposure to underlying where it is not possible to trade in the underlying (e.g., weather derivatives) create optionability where the value of the derivative is linked to a specific condition or event (e.g., the underlying reaching a specific price level)
Types of derivatives OTC and exchange-traded Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts are difficult because trades can occur in private, without activity being visible on any exchange. Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange. A derivatives exchange acts as an intermediary to all related transactions, and takes Initial margin from both sides of the trade to act as a guarantee.
Types of derivatives Futures/Forwards are contracts to buy or sell an asset on or before a future date at a price specified today. A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold, whereas a forward contract is a non-standardized contract written by the parties themselves. Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets.
Valuation of derivatives Two common measures of value are: Determining the market price For exchange-traded derivatives, market price is usually transparent (often published in real time by the exchange, based on all the current bids and offers placed on that particular contract at any one time). Complications can arise with OTC or floor-traded contracts though, as trading is handled manually, making it difficult to automatically broadcast prices. In particular with OTC contracts, there is no central exchange to collate and disseminate prices. Determining the arbitrage-free price The arbitrage-free price for a derivatives contract is complex, and there are many different variables to consider. Arbitrage-free pricing is a central topic of financial mathematics. The stochastic process of the price of the underlying asset is often crucial. A key equation for the theoretical valuation of options is the Black– Scholes formula, which is based on the assumption that the cash flows from a European stock option can be replicated by a continuous buying and selling strategy using only the stock. A simplified version of this valuation technique is the binomial options model.
Options In finance, an option is a derivative financial instrument that establishes a contract between two parties concerning the buying or selling of an asset at a reference price during a specified time frame. During this time frame, the buyer of the option gains the right, but not the obligation, to engage in some specific transaction on the asset, while the seller incurs the obligation to fulfill the transaction if so requested by the buyer. The price of an option derives from the value of an underlying asset (commonly a stock, a bond, a currency or a futures contract) plus a premium based on the time remaining until the expiration of the option. Other types of options exist, and options can in principle be created for any type of valuable asset. An option which conveys the right to buy something is called a call; an option which conveys the right to sell is called a put. The price specified at which the underlying may be traded is called the strike price or exercise price. The process of activating an option and thereby trading the underlying at the agreed-upon price is referred to as exercising it. Most options have an expiration date. If the option is not exercised by the expiration date, it becomes void and worthless. In return for granting the option, called writing the option, the originator of the option collects a payment, the premium, from the buyer. The writer of an option must make good on delivering (or receiving) the underlying asset or its cash equivalent, if the option is exercised.
Warrants In finance, a warrant is a security that entitles the holder to buy stock of the issuing company at a specified price, which can be higher or lower than the stock price at time of issue. Warrants and options are similar in that the two contractual financial instruments allow the holder special rights to buy securities. Both are discretionary and have expiration dates. The word warrant simply means to "endow with the right", which is only slightly different to the meaning of an option. Warrants are frequently attached to bonds or preferred stock as a sweetener, allowing the issuer to pay lower interest rates or dividends. They can be used to enhance the yield of the bond, and make them more attractive to potential buyers. Warrants can also be used in private equity deals. Frequently, these warrants are detachable, and can be sold independently of the bond or stock. In the case of warrants issued with preferred stocks, stockholders may need to detach and sell the warrant before they can receive dividend payments. Thus, it is sometimes beneficial to detach and sell a warrant as soon as possible so the investor can earn dividends. Warrants are actively traded in some financial markets such as Deutsche Börse and Hong Kong. In Hong Kong Stock Exchange, warrants accounted for 11.7% of the turnover in the first quarter of 2009, just second to the callable bull/bear contract.