A derivative is a financial contract that is based on (derived from) something else, either another financial instrument (a bond, shares, currency, etc) or a commodity (sugar, coffee, energy, etc). What the derivative is based on is called the underlying.

The three main types of derivatives are Swaps, Futures and Options.

Interest Rate Swaps

The exchange of cash flows representing interest receipts or payments on an agreed notional principal amount for an agreed period of time. Swaps are tools which allow for management of the interest basis of funds.

If you owned a property you were renting out and I had a savings account paying a fixed rate, you might want to swap your rent receipts for my interest receipts. You exchange the higher riskier rate (the rent payments which the tenants might not pay) for a lower less risky rate (the interest which the bank most probably will pay).

A company having borrowed money from a bank at a floating rate (6m LIBOR) might want to swap that for a fixed rate (6%) so that they are no longer at risk if interest rates go up. On one side they pay 6% (of the agreed notional principal) and receive 6m LIBOR, and on the other side they pay the 6m LIBOR straight out to repay their loan. They have converted a floating rate loan into a fixed rate loan.

The bank involved in the swap above would typically back it out with another swap, say paying 5.95% for 6m LIBOR. They make a profit from the .05% difference and are taking no risk with regards to interest rate changes.

The types of interest rate swap:

• Fixed / Floating: As in our example. This is the most popular type of swap. Also called a coupon or asset / liability swap.
• Basis swap: For example swapping 3m LIBOR for 6m LIBOR. Basis swaps are used a lot by mortgage companies that swap 1m for 3m (because they get mortgage repayments monthly).
• Currency swap (both fixed): Say fixed $ for fixed £.
• Currency basis swap (both floating): 3m $ LIBOR for 6m Yen LIBOR.
• Cross currency swap: Fixed £ for 3m CHF LIBOR.

Futures

A futures contract is a firm obligation to make or take delivery (or implied delivery through cash settlement) at a future date of a specific commodity at a specific price.

Futures are usually traded on an exchange (in England this is LIFFE). They are very standard. 3 month sterling interest rate futures are contracts to lend or borrow sterling for 3 months. They will have a delivery date (when the loan starts). So a June 3m £ future starts next June when one party borrows sterling from the other at the agreed rate for 3 months.

A future agreed directly with a bank is a Forward Rate Agreement (FRA). It can be tailored where there are no futures on the exchange that match our needs, or for currencies there are no futures in.

Options

A contract in which the holder buys (at a premium) the right but not the obligation to buy or sell an agreed amount of a commodity at a predetermined price over a specified time period.

An option granting the right to buy the underlying is a call option. An option granting the right to sell the underlying is a put option.

European options can only be exercised when the option expires. American options can be exercised at any time during the life of a contract.

The underlying (what we are buying the option on) can itself be a derivative. Exchange traded options often have a futures contract as the underlying.

Warrants

A warrant is a share option that is usually traded over the counter (OTC). Share options are usually traded on an exchange. The warrants are usually ‘given’ away as sweeteners on new deals but have a secondary market of their own. This asset class is nowhere near as popular as it used to be. Barings built, and probably lost, a huge fortune from Japanese warrant trading.

Volume

The derivatives market is mostly made up of derivatives based on:

• Interest rates: ( ~65% of the market). LIBOR, Bond rates, treasury bill rates, etc. The biggest derivative is the $ swap – swapping fixed rate dollars for floating rate dollars.
• Currencies: (~25%). Options and swaps on foreign exchange.
• Equity: (~5-10%). FTSE futures, Index swaps, etc.
• Commodities: (~0-5%).

(data correct as of the year 2000)

On the use of derivatives

Derivatives are used for speculation or hedging.

For speculation, derivatives give you leverage.

For example instead of buying a $10Million bond in the hope its price will go up, we can buy an option on that bond, which might only cost us $2000. The profit opportunity is almost the same (the price of the option slightly reduces our profit) but the risk is much less as the most we can lose is the option price ($2000).

For hedging, derivatives allow you to fix the price now for a trade in the future, or at least limit the rise / fall of that price.

For example an oil producer can arrange a futures contract for the sale of his oil in 1 years time. That way he knows exactly how much money he will make and can use that to invest. A UK company holding a US bond which is about to mature could buy an interest rate option to ensure the Dollar / Sterling rate did not reduce the value of its bond.