A Beginner Guide To Crypto Derivative

The value of a derivative is tied to the value of some underlying asset, group of assets, or benchmark. Over-the-counter (OTC) and exchange-traded derivatives are contracts between two or more parties (OTC).

You can use these contracts to trade various assets, each of which carries its unique set of risks. Changes in the underlying asset determine the prices of derivatives. These financial instruments are frequently used to gain access to certain markets and can be traded to mitigate risk. Derivatives can either be used to mitigate risk (hedging) or to assume risk with the expectation of a corresponding reward (speculation). Derivatives can transfer risk (and its associated rewards) from risk-averse parties to risk-seeking parties.

KEY TAKEAWAYS

  • Derivatives are financial contracts between two or more parties whose value is derived from an underlying asset, asset group, or benchmark..
  • Derivatives may be traded on an exchange or off-exchange.
  • Fluctuations in the underlying asset determine o Derivatives' prices.
  • Derivatives are typically leveraged instruments, heightening their potential risks and returns.
  • Futures contracts, forwards, options, and swaps are all examples of common derivatives.

Understanding Derivatives

A derivative is a type of complex financial security agreed upon by two or more parties. Traders utilize derivatives to gain access to specific markets and trade various assets. Derivatives are typically regarded as an advanced form of investing. Derivatives typically have stocks, bonds, commodities, currencies, interest rates, and market indexes as their underlying assets. Contract values are dependent on price fluctuations of the underlying asset.

Derivatives can be utilized to hedge a position, speculate on the direction of an underlying asset's price movement, or leverage holdings. These assets are frequently traded on exchanges or over the counter and are acquired via brokerages. One of the largest derivatives exchanges is Chicago Mercantile Exchange (CME).

It is essential to remember that when companies hedge, they are not engaging in commodity price speculation. The hedge is merely a method for each party to manage risk. Each party's profit or margin is incorporated into the price, and the hedge helps to protect those profits from price fluctuations in the commodity market.

In general, OTC-traded derivatives are more susceptible to counterparty risk, which is the possibility that one of the parties involved in the transaction will default. Unregulated, these contracts are traded between two private parties. To lessen the impact of currency fluctuations, the investor may wish to buy a currency derivative to guarantee a certain exchange rate. Currency futures and currency swaps are two derivatives that could be used to hedge this type of risk.

Particular Considerations

Initially, derivatives were used to maintain stable exchange rates for internationally traded goods. There was a need for a system to account for the varying values of national currencies among international traders.

Assume a European investor has only euro-denominated investment accounts (EUR). Suppose they purchase shares of a U.S. company using U.S. dollars on a U.S. exchange (USD). This means they are now subject to exchange rate risk while holding the stock. Exchange rate risk is the possibility that the euro will appreciate relative to the U.S. dollar. If this occurs, the investor's profits from the sale of the stock become less valuable when converted to euros.

A speculator who anticipates the euro to appreciate relative to the dollar could profit by utilizing a derivative whose value increases with the euro. An investor can speculate on the price movement of an underlying asset without actually owning or including the underlying asset in their portfolio if they use derivatives.

Types of Derivatives

Today's derivatives are based on a wide variety of transactions and have expanded applications. There are even weather-related proxies, such as the number of rainy or sunny days in a region.

Numerous derivatives can be utilized for risk management, speculation, and position leverage. The market for derivatives continues to expand, with products available to meet virtually any need or risk tolerance.

There are two categories of derivatives: locks and options. Futures, forward contracts, and swaps are all examples of lock products which bind the parties to the contract's terms from the outset and throughout its duration. The buyer or seller of an option product (such as stock options) has the option, but no duty, to acquire the underlying asset or security at the option's strike price on or before the option's expiration date. Futures, forwards, swaps, and options are the most typical derivative types.

  • Futures :
    A futures contract, or simply futures, is an agreement between two parties for the future purchase and delivery of an asset at an agreed-upon price. Futures are contracts that are standardized and traded on an exchange. Futures contracts are used by traders to hedge risk or speculate on the price of an underlying asset. The parties must honour an agreement to purchase or sell the underlying asset.
    For example, on November 6, 2021, Company A purchased an oil futures contract for $62.22 per barrel that expires on December 19, 2021. This is because the company needs oil in December and is concerned that the price will rise before it purchases. By locking in a price of $62.22 per barrel for oil, the seller becomes obligated to deliver the commodity to Company A at the contract's expiration, reducing the company's exposure to price fluctuations. Assume the oil price will reach $80 per barrel by December 19, 2021. Company A may accept the oil delivery from the futures contract's seller. Still, if it no longer requires the oil, it may sell the contract before its expiration and keep the profits.
    In this example, the buyer and seller of futures contracts hedge their risk. Company A required oil in the future and desired to hedge against the possibility of a price increase in December by establishing a long position in an oil futures contract. A seller could be an oil company worried about falling oil prices that wished to eliminate this risk by selling or shorting a December futures contract.
    It's also possible that both sides are merely speculators with divergent opinions on where December oil is headed. In this case, one party may benefit from the contract, while the other may not. Take, for instance, the West Texas Intermediate (WTI) oil futures contract that is traded on the CME and represents 1,000 barrels of oil. If the price of oil increased from $62.22 per barrel to $80 per barrel, the futures contract buyer would have earned $17,780 [($80 - $62.22) x 1,000 = $17,780].

The trader with a short position in the contract, the seller, would incur a loss of $17,780.

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Futures Settlements in Cash

At expiration, not all futures contracts are settled by delivering the underlying asset. If both parties to a futures contract are speculative investors or traders, it is unlikely that either would arrange for the delivery of a large quantity of crude oil. Speculators can terminate their obligation to buy or deliver the underlying commodity by closing (unwinding) their contract with an offsetting contract before its expiration.
Numerous derivatives are cash-settled, meaning that the trade's gain or loss is merely a cash flow to the trader's brokerage account. Cash-settled futures contracts include a variety of interest rate futures, stock index futures, and less common instruments such as volatility futures and weather futures.

  • Forwards:
    Forward contracts are similar to futures contracts, but they are not traded on an exchange. These contracts trade exclusively over the counter. The buyer and seller can customize a forward contract's terms, size, and settlement process. As OTC products, forward contracts expose both parties to a greater degree of counterparty risk.
    Credit risks involving the potential for one or more contracting parties to be unable to make good on their commitments are known as "counterparty risks." If one of the parties goes bankrupt, the other might be left high and dry.
    Counterparty risks can grow as the number of traders involved in a given forward contract does. This is because once a forward contract is in place, the parties can offset their position with other counterparties.
  • Swaps:
    Swaps are a type of derivative frequently used to exchange one cash flow for another. For instance, a trader could use an interest rate swap to convert a variable-rate loan to a fixed-rate loan or vice versa.
    Imagine that Company XYZ obtains a $1,000,000 loan with a variable interest rate of 6%. Perhaps XYZ is worried that rising interest rates will drive up the cost of this loan, or perhaps it has run into a lender who is hesitant to extend more credit so long as the company is exposed to variable-rate risk.
    Assume XYZ enters into a swap with Company QRS, which is willing to exchange the variable-rate loan payments for the 7% fixed-rate loan payments. So, XYZ will pay 6% interest to QRS on its $1,000,000 principal, while QRS will pay 7% interest to XYZ on the same amount. At the outset of the swap, XYZ will compensate QRS for the initial one per cent difference in swap rates.
    If the variable rate on the original loan drops to 5% because of a drop in interest rates, Company XYZ will owe Company QRS the difference of 3%. If interest rates were to increase to 8%, QRS would be required to pay XYZ the one percentage point difference between the two swap rates. The swap has accomplished XYZ's original goal of converting a variable-rate loan to a fixed-rate loan, regardless of future interest rate fluctuations.
    Swaps can also be used to exchange currency-exchange rate risk, loan default risk, or cash flows associated with other business activities. Swaps involving the cash flows and potential defaults of mortgage bonds are a highly popular type of derivative. In the past, they have been a bit too popular. The 2008 credit crisis was precipitated by the counterparty risk associated with such swaps.
  • Options:
    An options contract is a legally binding agreement between two parties in which one party agrees to purchase an asset from another at a later date and for a specified price. The primary distinction between options and futures is that the buyer of an option is not required to exercise the agreement to buy or sell. It is merely an opportunity, not an obligation like the future. Options, like futures, can be used to hedge or speculate on the underlying asset's price.
    Imagine that an investor owns 100 shares of a $ 50-per-share stock. They believe the value of the stock will increase in the future. Nonetheless, this investor is concerned about potential risks and opts to hedge their position with an option. An investor could buy a put option that gives them until a certain date the right to sell 100 shares of stock at a certain price (the strike price) and number (the underlying stock) (the expiration date).

The buyer of the put option anticipates that the stock price will fall to $40 per share before expiration and, as a result, plans to sell their shares at the option's $50 per share strike price. If the put option's strike price was the same as the stock's price when purchased, the investor would lose only $200 if the option was exercised. This strategy is a protective put because it mitigates the stock's downside risk.

Alternately, suppose that an investor does not own a stock valued at $50 per share. They anticipate a price increase within the next month. This investor could purchase a call option entitling them to purchase the stock for $50 before or at expiration. Let's pretend this call option was $200, and the underlying stock appreciated to $60 before it expired. The buyer can now exercise their option to purchase shares of stock valued at $60 per share for $50 per share, resulting in an initial profit of $10 per share. A call option corresponds to 100 shares, so the actual profit is $1,000, less the option's premium and brokerage commission fees.

In both cases, if the buyers choose to exercise the contract, the sellers are required to fulfil their obligations. At expiration, if the stock price is higher than the strike price, the put option is worthless, and the option writer keeps the premium. Suppose the stock's price at expiration is below the strike price. In that case, the call will expire worthlessly, and the call seller will retain the premium.

Positives and Negatives of Derivatives Positives

As the preceding examples demonstrate, derivatives can be useful for businesses and investors. They provide a means to.

  • Lock in prices
  • hedging against unfavourable rate fluctuations
  • Risk mitigation

These benefits frequently come at a low price.
Derivatives can frequently be purchased on margin, meaning that traders borrow money to purchase them. This makes them even more affordable.

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Disadvantages

Because derivatives are based on the value of another asset, they are difficult to value. Risks associated with over-the-counter derivatives include counterparty risks that are difficult to predict or quantify. Additionally, most derivatives are sensitive to the following.

  • Variations in the time remaining until expiration
  • The cost of holding the underlying asset
  • Interest rates

These variables make it difficult to correlate the value of a derivative and its underlying asset.
The derivative is susceptible to market sentiment and market risk because it has no intrinsic value (its value is derived from the underlying asset). A derivative's price and liquidity can go up and down independently of the underlying asset's price due to supply and demand.

Pros

  • Lock in prices
  • hedging against risk
  • Leverage able
  • Portfolio diversification

Cons

  • Complicated to comprehend
  • Vulnerable to counterparty default (if OTC)
  • Sensitive to supply and demand factors

Lastly, derivatives are typically leveraged instruments, and the use of leverage is a double-edged sword. It can potentially increase the return rate but also hastens the buildup of losses.

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