What are derivatives?
Let me take you through a short story where the relationship between a stock portfolio
and financial derivatives is explained.
Let’s take a look at the share price of a fictional company called Toy Giraffe Inc.
The share price has been going up and down in the $80 to $100 range over the past years.
Meet John.
He recently bought 1000 shares in Toy Giraffe Inc, at $100 per share.
He expects the share price to stay pretty much the same in the future, so no specific
expectations on his side of making a return from the share price rising, but he is really
excited about the expected annual dividend.
When we start discussing financial derivatives, the stocks that John bought are called the
underlying asset.
An example of a derivative is a call option.
John is approached by Jane, his stock broker, with an offer.
She offers $2 per share for her to receive the right to buy John’s shares at $120 per
share within 6 months.
If John and Jane agree on that transaction, then they have just entered into a derivative
contract.
The value of the call option depends on (“is derived from”) the value of the shares during
the next six months.
If the share price stays at $100 until the expiration date, then Jane will not exercise
her call option, as she has the right but not the obligation to do so.
In this scenario, John makes $2 per share on selling the call option to Jane, and Jane
loses $2 per share by having bought an option that she is not using.
If the share price goes up to $130, then Jane will exercise her call option, as it gives
her the right to buy shares from John as $120 while in the open market she can then sell
them for $130.
Her payoff is $8 in total: $10 gain on the share (the difference between $120 and $130),
minus the $2 cost of the option.
John’s payoff is also positive: he gained $20 when the share rose from $100 to $120,
does not benefit from the further increase of the share price as the shares are now transferred
to Jane, but makes an additional $2 from having sold the call option to Jane.
By selling a call option to Jane, he has capped (put a limit on) his potential gain from a
rising share price.
Call options provide the right to buy, put options provide the right to sell.
John is worried that the share price of Toy Giraffe Inc might drop.
Not so worried that he immediately sells his entire portfolio, but looking to get some
“insurance” against a very big drop in the share price.
Jane has a solution.
For $4 per share, she will give him the right to sell his shares to her at $80 per share
within 6 months.
If John and Jane agree on that transaction, then they have just entered into a derivative
contract.
The value of the put option depends on (“is derived from”) the value of the shares during
the next six months.
If the share price stays at $100 until the expiration date, then John will not exercise
his put option, as he has the right but not the obligation to do so.
In this scenario, John loses $4 per share by having bought an option that he is not
using, and Jane earns $4 per share from selling the put option.
If the share price goes down to $70, then John will exercise his put option, as it gives
him the right to sell shares to Jane at $80 while in the open market he can sell them
for only $70.
John faces a loss of $24 per share in total: he lost $20 when the share dropped from $100
to $80, plus paid a cost of $4 for the option.
His loss is capped (limited) at $24 per share, and he does not get hurt by a further decrease
of the share price.
Jane loses $6 per share: $10 from the share dropping from $80 to $70, minus the $4 income
she made when she sold the put option.
There are many other types of financial derivatives, that fall into the category of forwards or
futures.
A forward contract is an agreement between two parties, a buyer and a seller, to purchase
or sell something at a later date at an agreed price.
Futures are standardized forward contracts that trade on organized exchanges.
To illustrate forwards and futures, we could look at the expected annual dividend on Toy
Giraffe Inc shares.
One year from now, the company is expected to pay $4 per share in cash dividend.
This is not an absolute guarantee, it is an estimate based on historical dividend payments
and expectations about future free cash flow of the company.
Jane has an offer for John on this: $3 right now in return for the $4 dividend that is
expected to be paid next year.
The 25% discount covers the time value of money as well as the uncertainty around the
dividend payout.
A very different type of financial derivative is a swap contract.
John owns $100,000 worth of Toy Giraffe Inc stock, while Jane owns $100,000 worth of ABC
Corp stock.
Both of them want to keep their underlying asset, but are interested in getting the returns
on the other person’s portfolio.
To achieve this, they could enter into an equity swap contract.
At the end of for example a two year contract, the total returns on the Toy Giraffe Inc stock
(share price gains or losses, and dividends) are exchanged, or swapped, for the total returns
on the ABC Corp stock.
A financial derivative is any security whose value is derived from the value of another
(underlying) asset.
We discussed options, forwards, futures and swaps in this video.
Want to learn more about business, finance, accounting and investing?
Then subscribe to the Finance Storyteller YouTube channel, and start watching the next
video in the recommendations on the screen.
Thank you.