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Derivatives

Introduction to Derivatives

  • What are Derivatives ?

    • Derivatives are one of the essential features of a mature financial system. As the name clearly suggests derivatives derive their value from something (asset).
    • The price of the derivatives is the price of the underlying asset in the derivatives such as a stock, a bond, a commodity, an interest rate, a currency or a cryptocurrency.

  • Uses of Derivatives

    • Hedging

      • A hedge is an investment that is made with the goal of lowering the risk of unfavourable changes in an asset's price. A hedge often entails taking an opposite or offsetting stake in a connected security.
      • Hedging involves a trade-off between risk and reward; while it lowers possible danger, it also limits prospective gains.

    • Speculations

      • Speculation, often known as speculative trading, is the act of engaging in a financial transaction that carries a considerable risk of losing value but also carries the hope of a sizable gain or other significant value. With speculation, the chance of a sizable gain or other form of compensation more than offsets the risk of loss.

    Hedging aims to lessen the risk, or volatility, associated with a security's price change as opposed to speculation, which entails seeking to profit from a security's price fluctuation.

    By holding positions in an asset that are counter to those the investor currently has, hedging aims to reduce the volatility that is related to its price. Contrarily, the primary goal of speculating is to make money by placing bets on the future direction of an asset.

Derivatives Types
Financial derivatives combine usually of 4 most important parameters - Futures, Options, Swaps and Forwards.

  • Forwards

    • A forward contract is an agreement between two parties to buy or sell an asset at a predetermined price on a specific date in the future. It mostly serves hedging needs (insuring against price risk).
    • You could enter into a forward contract, for instance, if you are an onion farmer who is concerned about the volatility of onion prices. A contract to sell 100 kgs of onions to Arvind @ 40 per kg on 1/1/2018.

  • Futures

    • A forward contract and futures are comparable. The distinction is that futures are standardised contracts to buy or sell an asset at a predetermined price in the future. Consequently, they are tradable on stock exchanges.
    • The cost of the underlying asset determines the futures' value. Futures can be used for speculation or hedging. Buying and selling an asset with the intention of making a profit is known as speculation.

  • Options

    • Two different alternatives are available. The right to buy an asset at a predetermined price on or before a given date is provided by a call option. The exercise price is the agreed-upon amount. It should be mentioned that the holder has the choice not to purchase the asset.
    • The premium is what you pay to buy the option. It stands for the sum that the call option buyer must pay in exchange for the right, but not the responsibility, to exercise the option.

  • Swaps

    • A contract known as a swap allows two parties to trade future cash flows for a specified period of time. An interest rate swap is the most typical kind of swap. Parties concur to trade interest rate payments in this.
    • Consider a loan that Bank A issued with a variable interest rate based on the market. Interest rates will change over time. A loan with a fixed interest rate has been made by Bank B. They are able to trade their interest payments through a contract.

Futures and Options are two most important types of derivatives because they are traded on exchange.

Futures in Depth

  • Futures are financial derivative contracts that bind parties to buy or sell an asset at a specified future date and price. Regardless of the market price at the date of expiration, the buyer or seller must buy or sell the underlying asset at the agreed-upon price.

  • Futures are of 5 types primarily- Commodity Futures, Stock index future, Currency futures, Precious Metals, U.S. treasury futures.

  • Futures are traded through Futures contracts on exchanges.Futures Contracts are a type of financial instrument through which a buyer can wager on the future price of a commodity or other security.These exchanges are responsible for the standardisation of various parameters in these contracts. The Commodity Futures Trading Commission oversees futures markets (CFTC).

  • Hedging through futures

    • Futures can be used to hedge against price fluctuations in the underlying asset. This helps in lowering the risk of te investors.

  • Speculation through futures

    • A trader can make predictions (speculate) about the course of a commodity's price using a futures contract. The trader is at a profit position if the price of the contract rises above the contract price before expiration.

  • Buyer and Seller

    • Long Contract

      • A trader buys a long contract (long position) with an prediction that the prices of the commodity rise above the current level and they are benefitted.

      • Prices rise- The position holder is at a profit.

      • Prices fall- The position holder is at a loss.

    • Short Contract

      • A trader buys a short contract (long position) with an prediction that the prices of the commodity fall below the current level and they are benefitted.

      • Prices rise- The position holder is at a loss.

      • Prices fall- The position holder is at a profit.

Options in Depth

  • A derivative, or contract, is an option that grants the buyer the right , but not the obligation, to purchase or sell the underlying asset by a particular date (expiration date) at a particular price (strike price). Options can be classified in two types which are Call and Put Options.

  • Use Cases

    • Hedging

      • An investor can purchase put options on a stock if they anticipate that specific equities in heir portfolio will lose value but do not want to permanently exit the trade.

    • Speculation

      • An investor can buy calls or sell puts to profit from a gain in price if they anticipate the price of a security will increase. The investor's overall risk while purchasing call options is capped at the option premium.

    • Leverage

      • Options are essentially leveraged instruments since they enable investors to increase the possible upside profit by investing less money than would otherwise be necessary to trade the underlying asset.

    • Benefit from downside

      • In options market, a trader can benefit from the downside of the market by betting on “Put options” where the trader gets the right to sell (not obligation) the underlying asset.

  • Call Options

    • You can purchase a “call” option with less capital than the underlying asset if you believe the price of an asset will increase.

    • This strategy is adopted by traders who are bullish and confident about a particular stock, Exchange Traded Fund and want to minimise their risks.

  • Put Options

    • A put option gives the buyer the right to sell an underlying asset at a set price.

    • This strategy is adopted by a trader who is bearish in nature and want to take less risk compared to short-selling.

  • Buyer and Seller

    • Call Buyer

      • Executes buying call option and pays the premium.
      • These traders are bullish in nature.
      • Profits are unlimited and losses are capped to the premium paid.
      • A call buyer has the right to execute the buying but he/she is not obligated to do so.

    • Call Seller

      • Executes selling of call option and receives the premium.
      • These traders are not bullish.
      • Profits are limited to the premium and losses are unlimited.
      • Moreover, they are obligated to sell the derivative in case the call buyer is willing to execute the option.

    • Put Buyer

      • Executes buying of a put option and pays the premium
      • These traders are bearish.
      • Profits are unlimited and losses are limited to the premium paid.
      • A put buyer has the right to sell the option but he/she is not obligated to do so.

    • Put Seller

      • Executes selling of a put option and receives the premium
      • These traders are not bearish.
      • Profits are limited to the premium and losses are unlimited.
      • A put seller is obligated to buy when the put buyer wants to sell the derivative.

Derivatives Protocols

  • Ever-expanding markets inevitably create their own derivatives markets, which may eventually grow to be orders of magnitude larger than their underlying markets.
  • Due to the fact that, in contrast to traditional finance, decentralised derivatives can be generated by anybody in an entirely permissionless and open manner, many individuals in the decentralised finance field are quite optimistic about their potential.
  • There are various derivative protocols that are emerging in the decentralised finance space. Henceforth we are going to discuss Yield Protocol, Synthetix and others.

  • Yield Protocol

    • A protocol for collateralized fixed-rate, fixed-term borrowing and lending called Yield Protocol is built on Ethereum. Yield employs a class of tokens known as fyTokens to accomplish its objectives (fixed yield tokens).
    • After a defined maturity date, fyTokens are Ethereum-based ERC-20 tokens that can be exchanged for an underlying asset. For instance, following the maturity date, you can exchange one fyDai token for one Dai.
    • Yield is a crucial protocol that gives Ethereum access to fixed-rate goods. To build strong interest-bearing apps for investors, it can be strongly connected with protocols like MakerDAO and Compound.
    • As more traditional investors start using DeFi and their portfolios start to require these kinds of assets, the demand for fixed income components will increase.

  • Synthetix

    • On the Ethereum blockchain, synthetic assets can be issued via the Synthetix (SNX) protocol. Gold and silver-like synthetic commodities, synthetic cryptocurrencies, inverse synthetic cryptocurrencies, synthetic cryptocurrency indexes, and synthetic fiat currencies are all supported by Synthetix. The platform exposes non-blockchain-based assets to the cryptocurrency ecosystem, resulting in the development of a more developed financial market.
    • A synthetic asset issuance protocol built on Ethereum is called Synthetix. Synthetic assets are financial instruments in the form of ERC-20 smart contracts known as "Synths," which track and give the returns of another asset without requiring you to retain that asset.
    • They are comparable to derivatives in traditional finance. On Kwenta, Synthetix's decentralised exchange, you can trade Synths, which include cryptocurrencies, indices, inverses, and physical assets like gold (DEX). The Synthetix Network Token (SNX), the company's native token, is utilised as collateral for issued Synths.

  • UMA

    • A blockchain-based open-source protocol called UMA uses Ethereum (ETH). Anyone can create decentralised financial products—financial services that are available to everyone—using UMA. Also, the team's objective of establishing "universal market access" is where the protocol's name, UMA, originates.
    • The UMA protocol, which is supported by the UMA token, enables users to create their own synthetic assets—digital tokens that simulate and track the value of any physical item. On the platform, these digital assets are also referred to as priceless financial contracts. According to the UMA protocol, decentralised financial contracts have the ability to remove all entry barriers for any financial market

  • Hegic

    • In a trustless way, Hegic, a decentralised trading system built on the Ethereum blockchain, establishes, maintains, and settles Hedge contracts. The hedge contracts are on-chain contracts that resemble options and let traders sell their assets at a predetermined price at a later time. On the Hegic platform, option prices are automatically set lower than they are on centralised exchanges.