The term "Derivative contract" is well-known in all developed countries, not only because of its huge market size and large trading volumes, but also because of its hand in greasing the great financial crisis of 2008.
However, in Pakistan, despite the availability of financial derivative instruments in the market - though very few - beyond the shadow of doubt, only students taking finance courses and employees working in financial institutions are aware of this investment vehicle, and many of them still afraid to get down to the nitty-gritties.
Definition is perplexing The irony is that the definition of a derivative contact - A financial contract the value of which is derived from the values of one or more underlying assets, reference rates, or indices of asset values, or credit-related events - sounds complex for starters, when it can be better explained in layman terms.
To begin with, let's first understand the meaning of a simple contract: "A contact is a voluntary, deliberate, and legally binding agreement between two or more competent parties".
An example of a simple contract Assume that a party "B "agrees to buy a piece of land from a party "S" after two months for Rs 10 million. In this case, both parties have an obligation to execute the transaction at the given date in the future (as mentioned in the contract) at the agreed price. For ease, assume that both the parties didn't pay any amount to each other at the start of the contract.
An underlying asset In the above example, an underlying asset is a piece of land on which the contract price has been established. Moreover, commodities, real estate, metals, shares, stock indexes, and fixed income securities, etc are also widely used as underlying assets in various contracts.
Execute a contract Suppose that two months have been passed since the initiation of the contact. On the contact expiration day, the party "S "will deliver the land to the Party "B" in exchange for Rs 10 million.
Derivate contracts are similar to real life contracts In essence, simple derivate contracts are also similar to these real life contracts. However, in derivatives, investors usually enter into contracts to either capitalise on the future price direction of underling assets or hedge price risk.
Derivative contracts "a win-lose situation" Let's reconsider the above mentioned example to understand how parties could earn profits by entering into a derivate contact.
In derivative contracts, a seller (S), who wants to sell an underlying asset (land) at a contract price, usually doesn't own an underlying asset. Instead, s/he purchases an underlying asset from a market at the running market price on the contract expiration date (after two months from the date of contract initiation) and than delivers the underlying asset to a buyer (B) at the pre-determined contract price (Rs 10 million).
Likewise, it is not necessary that a buyer (B) will keep or use an underlying asset (land) after delivery since a buyer usually sells an underlying asset later in the market at the market price.
Assume that at the contract expiration date, the price of land increases to Rs 13 million in the market. Despite an increase in the market price, both the parties have an obligation to execute the transaction at the agreed contract price at Rs 10 million.
Here, party B will earn a net profit of Rs 3 million by purchasing the land from party S for Rs 10 million and then on the same day sell it in the market for Rs 13 million (the market price). On the flip side, S will make a loss of Rs 3 million as it will deliver the land for Rs 10 million to B, when market price is actually Rs 13 million.
Here, assume that S doesn't own the piece of land and instead had bought the land from the market at the price of Rs 13 million to meet contract obligation, which is to deliver the land to B for Rs 10 million.
What compels the parties to enter into this contract? In such contracts, parties usually take a risk to earn profits. For instance: The B had thought of increase in land prices after two month at the time of contact, and consequently enters into the contract on the buy side. In short, buyer's motivation is to buy low at the contract price and sell high later in the market.
On the flip side, the S had thought of the decline in land prices after two months at the inception of the contract, which, unfortunately, was a wrong prediction and resulted in losses. Here, the seller's strategy was to buy low at the market price and sell high at a contract price.
Hedging Investopedia explains hedge as "Making an investment to reduce the risk of adverse price movements in an asset". To explain this, assume that a farmer (seller) enters into a contract (derivative) to sell a ton of basmati rice to an exporter (buyer) at $500 per ton after four months. Here, the underlying asset is Basmati Rice.
These two parties have hedged themselves against future price direction of rice. In this case, the farmer is uncertain about the future price direction of rice or afraid that prices might decline in future.
Therefore, by entering into this derivative contract, the framer has locked the selling price of rice, and consequently hedged its revenues from a possible decline in the price of rice. No matter which direction the prices move, the seller will receive $500 for a ton of rice.
On the other hand, the rice exporter is also uncertain about the future price direction and afraid that prices might rise. Therefore, simultaneously, by entering into this contract, the exporter has hedged its position as it will buy a ton of rice for $500 per ton even if market price rises above $500 per ton.
The above examples clearly show the mechanism of a derivative contract. Though there are many types of derivative contracts, all derivative contracts are an extension of a simple contract, explained above.
COURTESY: Economics and Finance Department, Institute of Business Administration, Karachi, prepared this analytical report for Business Recorder.
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