Derivatives are often perceived as very complicated financial vehicles and as a result are often overlooked or worse misunderstood. The purpose of this article is to give beginner investors a good overview and foundational understanding of derivatives so that you can use this information to make well informed financial decisions. It is important to understand the nature of derivatives as they can be very lucrative investment vehicles. That said they need to be well understood because they are also considerably high risk instruments.
What is a derivative ?
A derivative is a financial instrument that derives value from other underlying assets, that the investor will not own.
This is the first critical characteristic of a derivative which is that through investing in a derivative you will not own the underlying assets in which the derivative is correlated to. This concept may be a bit hard to wrap your head around , so for the purpose of explaining this principle I am going to use an example.
The best way to demonstrate this principle is with the example of Contract for Difference (CFDs) products.The most known and applied application of CFDs is stock CFDs So if you for example invest in a Google CFD, you will not own the underlying asset which in this case would be Google stocks, but you will still be able to profit from Google stock if it performs well. The CFD will mirror the performance of the underlying stock, therefore if Google performs well you will profit from the Google CFD and if Google stock performs badly you will make a loss off the Google CFD. CFDs are one application or format of derivatives. Derivatives can also be applied in other ways and are not only limited to CFDs.
Different application of derivatives
Perhaps you have heard of Futures and Options? These are two different financial instruments that are classified as derivative products.
Futures are a derivative that mainly applied to the agricultural sector. Futures are financial contracts that create an obligation for a buyer to by certain assets from the seller for an agreed amount on a future determined date. For example if Farmer A was to set up a future contract with buyer B , in 2019, they may agree that buyer B will purchase 50kg of wheat from Farmer A at the price of R50 per 50kg on the 16 of August 2020.
This could be to the benefit of Farmer A. If the wheat market crashes and the price for wheat falls to R30 per 50kg, Farmer A will be protected from the price drops of wheat in the market. However, if the wheat market reaches highs in 2020 and wheat starts trading for R100 per 50kg Farmer A will make a loss. Futures are ideally used to hedge against market volatility.
When you purchase a future contract there is a date in which the future contract will expire, and will no longer be valid. So looking at the example above, the wheat future contract will expire on the 26th of August 2020.
Options are also another financial instrument that is classified as a derivative product. Options just like futures are a financial contract that have a beneficiary use in the financial markets and business as well. The person who buys an option is awarded the right to purchases a known asset , for a known price by a known date. They have the right to purchase the agreed asset, but there is no obligation for them to buy the respective asset. Furthermore the period for which the option contract is in force protects the buyer of the purchaser of the option contract, for when the option contract is enforce the seller cannot sell the asset to another buyer.
This all may seem a bit abstract so I am going to demonstrate the practical application of option contracts through some examples.
Khutso wishes to sell her car to Sanjit. The price she wishes to sell the car for is R250 000 , Sanjit is interested in the car but does not have all the money in cash at the moment. He insists that he can raise the money in a month. Therefore, Khutso decides that she will sell Sanjit an option contract on the car for R10 000 and the option will expire after a month. Sanjit purchases the option on the car. This means that for a month (in compliance with the agreement) Khutso cannot sell the car to anyone else. During this period Sanjit has the right to purchase the car, but he is not obliged to purchase the car (he does not have to buy the car, he can choose to not buy the car). If Sanjit buys the car he pays R250 000, allows Khutso to make in total R260 000, from the whole deal , because she earned an additional R10 000 from the contract option. If Sanjit chooses not to purchase the car Khutso still makes R10 000 from the deal from the sell of the option contract to Sanjit.
In this example the option is concerned with the right to buy and therefore it is called a Call option. Using this example let’s consider why these respective parties may want to enter an option contract with each other. For Sanjit, the benefit is that for a month he is afforded the exclusive right to purchase the car for the set price stated in the agreement. Therefore if another buyer makes a higher offer on the price of the car, or the value of the car goes up Sanjit is only obliged to pay the R260 000. Khutso during the period that that the contract is enforce cannot sell the car to another buyer , even if its for a higher offer because she is bound by the agreement. So you may ask why would Khutso enter the agreement? The benefit of such an agreement is that if Khutso was not getting many potential buyers for the car, she can still earn money on the asset even if it is not purchased. So for instance if Sanjit did not purchase the car, and there were no other buyers in the case she would still have the benefit of R10 000 which she earned from selling the option contract.
Thomas owns a successful business that consists of a chain of grocery stores and an investor called Andre’ wishes to invest in half of his business. Thomas is concerned with sharing 50% of his business with Andre’, and wants to have the option to exit the business completely if they have disagreements on how to operate and manage the business. He seeks advise and is told that he should sell an option contract on the business to Andre’ that allows Andre’ to purchase the remaining 50% of the business. Thomas under advise states the duration of this contract is 10 years. He prices the value of the remaining 50% of the business at R2.5 million. Andre agrees to buy this option for R500 000. This is an option concerning the right to sell and therefore is called a Put option
This agreement could be beneficial to either Thomas or Andre’.
Lets say that the business starts to make a loss do to Andre’s management style , and the overall value of the business declines, Thomas can execute his rights in terms of the option and sell the remaining 50% of the business to Andre’ at the fixed price of R2.5 million ( granted he does so within the 10 years). In such as instance because the right to execute the option is Thomas’s, Andre’ would have to buy remaining 50% of the business for the R2.5 million. This will be to the benefit of Thomas.
On the other hand, if the company was to do well and increase in value and for any reason Thomas wished to sell the remaining 50% of the business, he would not be able to sell to any other buyers other than Andre. Furthermore , he would not be able to sell it for higher than R2.5 million , which would be to the benefit of Andre’.
Option contracts are used a lot of in business to facilitate several transactions and as highlighted in this article they can be critical in maximising profits in a deal and commercial transaction.