Derivative Contracts

Derivative financial trades are gaining prominence in trading. A derivative trade is one whose value depends on another instrument's value. We are going to look at Forward Contracts, Options, and Products.

Forward Contract

In a normal contract, usually referred to as a spot contract, the delivery date is as close as possible to the trade date. Forward contracts are agreements to do the delivery sometime in the future. For example, consider a French company that wants to buy a commodity from an American company in two months. The company, usually, would do financing in francs. If there is a high degree of uncertainty in the franc/dollar exchange rate, the company cannot afford to take risk. So, it enters into a forward contract exchange rate deal, paying an agreed amount of francs for the required dollars. The price would be offered by the bank who is carrying out the deal based on the market's perception of where the exchange rate is likely to go in the next two months. Such a deal is said to have a tenor of two months. Now, we can model the forward contract as follows:

One important thing to be noted is the tenor. It is the period between the trade date and the delivery date. Prices are generally quoted on the market with a a particular tenor in mind. However, the tenor is simply not the duration between trade and delivery dates. For example, let us assume that the above-mentioned contract was traded on June 10. If, August 10 happened to be a Saturday, then August 12 is the actual delivery date. Holidays have a big impact on how these dates are calculated. Note that we have to consider the holidays for both the parties. In this kind of structure, the calculation of the delivery date is not something that can be done by the trade date and tenor alone. This means that the market should have a date calculation routine that adjusts for holidays.

Option

In the French company example given above, the forward contract is a valuable tool in reducing the risk of an exchange rate change that would cause them to pay more. But the company does run the risk of losing out should the exchange rate change in their favor. So, according to the financial manager, he has to buy the commodity on the spot market or forward contract based on his estimate of exchange rate change. Options are more helpful in this respect. An option gives the buyer the right to buy dollars at a prearranged exchange rate if the holder wishes. If the franc goes down, the company can exercise its option and buy the dollars at the prearranged price; otherwise they can ignore the option and buy on the spot market. The bank charges a premium to the company to sell them the option, so the bank now manages the risk. Many features of the option are similar to a normal contract. Like a contract, options have counterparties and trade dates. Other features of the option include expiration date, the amount of premium, and date the premium is delivered. Thus, the following model is obtained, which considers an option to be a subtype of contract:

Note: The { derived } indicator is a reminder to the implementor that it is not something that is actually stored or calculated.

In the above model, the terms call and put are from the trader's vocabulary. A call is an option to buy, while a put is an option to sell. We can buy or sell a call, or buy or sell a put, which gives rise to four combinations. Representing this in the model is slightly tricky. What we have done is use the terms long and short for options only to indicate the state of the option rather than the contract. So, if we sell an option to buy German marks, then this option would be classified as a short call; if we buy an option to sell marks, this would be a long put.

Product

This pattern emerged as a consequence of the need to separate a salesperson's (or customer) view from the trader's (or risk manager) perspective. For example, there are more advanced options called combinations, which are a composite of other options; when managing risk, the traders do not actually concern themselves with combinations. A combination is nothing more than the component contracts, for them. It is the customer and the salesperson who form the combination and think of the contracts as a combination. This leads us to the following model:

Here, the product reflects the perspective of sales. In risk analysis, the way in which contracts are combined as products is ignored.

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