Derivatives: for those who can't get enough
A derivative is a derivative financial instrument that entitles or obligates parties to perform certain actions with respect to an asset.
Swaps
A swap is a temporary exchange of assets in the course of trading on an exchange. The parties can exchange securities, currencies and payments. In addition, they undertake to return the same securities to each other after a certain period of time or to make reverse payments.
A swap transaction always consists of two transactions with the same asset or commodity, but either with delivery at different times or with different terms.
Interest rate swaps
An interest rate swap (IRS) is an agreement in which the parties exchange obligations:
Bank A and Bank B entered into a contract. The first agreed to pay the second a fixed rate of 5% of $100 million each month. Bank B agreed to pay a monthly floating rate of the same amount.
Thus, if the floating rate is higher than 5%, Bank A wins (because it only paid 5%).
Conversely, if the floating rate is lower than 5%, Bank B wins (because it was paid 5% and spent only a fraction of that interest).
Currency swaps
A currency swap is a combination of two opposite transactions to exchange currency for the same amount on different dates. The execution date of the first transaction is the value date, and the second reverse transaction is the swap end date.
Let's say the client has ₽50 thousand in his brokerage account. He bought $1 thousand to be delivered tomorrow at the rate of ₽66 per dollar. The next morning, the customer must be delivered in dollars. However, since the customer does not have enough money to pay for the $1k, the broker moves the value date to the next day. This procedure will be repeated until the client either closes the position, or deposits enough money into the account to pay for the dollars purchased.
Thus, when the dollar rate rises to ₽70, we will still be able to buy it at ₽66 (with an open trade). However, keep in mind that you will have to pay a commission each time you move your position.
The date of the second transaction (selling the purchased currency) depends on the swap contract. It can be in a week, a month or a year.
Credit default swaps (CDS)
A credit default swap (CDS) is a financial instrument that is similar to insurance. The buyer pays a premium to the issuer of the swap, which can be a one-time or regular payment. For this, the issuer undertakes to repay the loan that the buyer has issued to a third party, if the latter fails to repay - defaults.
Issuer - an organization that issues securities.
Default - the inability to meet obligations to repay debts or pay interest on securities, as well as any other breach of contract.
Your company, Centurion, has a lot of free money, and you want to invest $1 million in a high-risk company, let's call it Cantus, and get 10% per annum for 10 years (and after that you get back the money you spent). But for legal reasons, you can't do high-risk transactions.
That's where a third party comes in, Observer, which has a "reliable" rating. You and Reviewer agree to invest your money in Cantus through them. And the former, in turn, undertake to pay you all the money you invested, in the event of the collapse of Cantus, but ask for a percentage of your income in return.
Options
Option - a contract under which the holder receives the right (but not the obligation) to buy or sell a certain asset at a predetermined price, at a time in the future specified in the contract.
Kolya has 1 ETH, worth $1800. He issues an option to buy that ETH from him in a week for $1600.
Vasya thinks that 1 ETH will be worth $2200 in a week. And if he buys Kolya's option - he can immediately buy at $1600 in a week and sell at $2200 in the market.
However, Vasya has to pay a premium of $100 for Kolya's option.
So, 1 ETH is worth $1800, in a week there could be 2 scenarios:
- The market price of ETH <= $1600. Vasya can still buy it from Kolya, but there is no profit. And Kolya got his $100 premium from selling the option.
- The market price of ETH > $1600. Now Vasya wins, because he can buy ETH below market price. However, don't forget about the $100 he paid to Kolya for the option.
Swaptions
A swaption is a derivative instrument of a swap and an option. That is, the holder of a swaption reserves the right (but is not obliged) to start a swap operation after some predetermined time.
Futures
Futures - a standardized forward contract.
A forward contract is a contract under which one party undertakes to transfer a commodity to the other party or to fulfill an alternative monetary obligation at a time specified in the contract, and the buyer undertakes to accept and pay for the underlying asset.
In other words, it is the same option, only now with a mandatory condition of execution!
Example:
Take the example of Vasya and Kolya.
Now, even if the market price of ETH falls to $1000 and the futures contract stipulates a price of $1600, Vasya can't refuse to buy. He must make the trade at a loss.
Warrants
A warrant is a security that gives the holder the right to buy a proportionate number of shares at a specified price within a certain period of time, usually at a lower price than the current market price.
That sounds like an option, doesn't it?
But there are two key differences:
- Warrants can only be issued by a stock issuer, while options can be issued by anyone.
- Warrants generally involve a much larger time difference between the first and second transaction. The closer the date the warrant is exercisable, the lower the price of the warrant.
Kolya wants to buy a warrant for shares of Centurion stock.
The warrant says that in one year Kolya is guaranteed to buy one share of the company for $35.
Today, Centurion stock is trading at $40 and the warrant is worth $10. It turns out that our deal will only be successful if the stock is worth > $45 in a year.
Contract for difference (CFD)
It is such an agreement between two parties - the seller and the buyer to transfer the difference between the current value of the asset at the time of the contract (opening a position) and its value at the end of the contract (closing a position).
In general, it is very similar to a normal sale. However, neither party sells or receives the asset.
If the price of the asset increased between the first and second transaction, the buyer will receive the price difference from the seller. If the price went down, the seller will receive the price difference from the buyer.