Derivatives 101

by Kristina Zucchi
Investing has become much more complicated over the past decades as various
types of derivative instruments become created. But if you think about it, the use of
derivatives has been around for a very long time, particularly in the farming industry.
One party agrees to sell a good and another party agrees to buy it at a specific price
on a specific date. Before this agreement occurred in an organized market, the
bartering of goods and services was accomplished via a handshake.

The type of investment that allows individuals to buy or sell the option on a security is
called a derivative. Derivatives are types of investments where the investor does not
own the underlying asset, but he makes a bet on the direction of the price movement
of the underlying asset via an agreement with another party. There are many
different types of derivative instruments, including options, swaps, futures and
forward contracts. Derivatives have numerous uses as well as various risks associated
with them, but are generally considered an alternative way to participate in the
market. (Follow this tale of a fictional chicken farm to learn how derivatives work in
the market. For more information, see The Barnyard Basics Of Derivatives.)

A Quick Review of Terms

Derivatives are difficult to understand partly because they have a unique language.
For instance, many instruments have counterparty, who is responsible for the other
side of the trade. Each derivative has an underlying asset for which it is basing its
price, risk and basic term structure. The perceived risk of the underlying asset
influences the perceived risk of the derivative.

Pricing is also a rather complicated variable. The pricing of the derivative may feature
a strike price, which is the price at which it may be exercised. When referring to fixed
income derivatives, there may also be a call price which is the price at which an
issuer can convert a security. Finally, there are different positions an investor can
take: a long position means you are the buyer and a short position means you are the
seller.

How Derivatives Can Fit into a Portfolio

Investors typically use derivatives for three reasons: to hedge a position, to increase
leverage or to speculate on an asset's movement. Hedging a position is usually done
to protect against or insure the risk of an asset. For example if you own shares of a
stock and you want to protect against the chance that the stock's price will fall, then
you may buy a put option. In this case, if the stock price rises you gain because you
own the shares and if the stock price falls, you gain because you own the put option.
The potential loss from holding the security is hedged with the options position.

Leverage can be greatly enhanced by using derivatives. Derivatives, specifically

options are most valuable in volatile markets. When the price of the underlying asset
moves significantly in a favorable direction, then the movement of the option is
magnified. Many investors watch the Chicago Board Options Exchange Volatility Index
(VIX) which measures the volatility of the S&P 500 Index options. High volatility
increases the value of both puts and calls.
Speculating is a technique when investors bet on the future price of the asset.
Because options offer investors the ability to leverage their positions, large
speculative plays can be executed at a low cost

Trading
Derivatives can be bought or sold in two ways. Some are traded over-the-
counter (OTC) while others are traded on an exchange. OTC derivatives are contracts
that are made privately between parties such as swap agreements. This market is the
larger of the two markets and is not regulated. Derivatives that trade on an exchange
are standardized contracts. The largest difference between the two markets is that
with OTC contracts, there is counterparty risk since the contracts are made privately
between the parties and are unregulated, while the exchange derivatives are not
subject to this risk due to the clearing house acting as the intermediary.

Types
There are three basic types of contracts-options, swaps and futures/forward
contracts- with variations of each. Options are contracts that give the right but not
the obligation to buy or sell an asset. Investors typically will use option contracts
when they do not want to risk taking a position in the asset outright, but they want to
increase their exposure in case of a large movement in the price of
the underlying asset. There are many different option trades that an investor can
employ, but the most common are:

• Long Call
If you believe a stock's price will increase, you will buy the right (long) to buy
(call) the stock. As the long call holder, the payoff is positive if the stock's price
exceeds the exercise price by more than the premium paid for the call.
• Long Put
If you believe a stock's price will decrease, you will buy the right (long) to sell
(put) the stock. As the long put holder, the payoff is positive if the stock's price
is below the exercise price by more than the premium paid for the put.
• Short Call
If you believe a stock's price will decrease, you will sell or write a call. If you sell
a call, then the buyer of the call (the long call) has the control over whether or
not the option will be exercised. You give up the control as the short or seller.
As the writer of the call, the payoff is equal to the premium received by the
buyer of the call if the stock's price declines, but if the stock rises more than the
exercise price plus the premium, then the writer will lose money.
• Short Put
If you believe the stock's price will increase, you will sell or write a put. As the
writer of the put, the payoff is equal to the premium received by the buyer of
the put if the stock price rises, but if the stock price falls below the exercise
price minus the premium, then the writer will lose money.

Swaps are derivatives where counterparties to exchange cash flows or other variables
associated with different investments. Many times a swap will occur because one
party has a comparative advantage in one area such as borrowing funds under
variable interest rates, while another party can borrower more freely as the fixed
rate. . A "plain vanilla" swap is a term used for the simplest variation of a swap. There
are many different types of swaps, but three common ones are:
 • Interest Rate Swaps
Parties exchange a fixed rate for a floating rate loan. If one party has a fixed
rate loan but has liabilities that are floating, then that party may enter into a
swap with another party and exchange fixed rate for a floating rate to match
liabilities. Interest rates swaps can also be entered through option strategies.
A swaption gives the owner the right but not the obligation (like an option) to
enter into the swap.

• Currency Swaps
One party exchanges loan payments and principal in one currency for payments
and principal in another currency.

• Commodity Swaps
This type of contract has payments based on the price of the underlying
commodity. Similar to a futures contract, a producer can ensure the price that
the commodity will be sold and a consumer can fix the price which will be paid.

Forward and future contracts are contracts between parties to buy or sell an asset in
the future for a specified price. These contracts are usually written in reference to
the spot or today's price. The difference between the spot price at time of delivery
and the forward or future price is the profit or loss by the purchaser. These contracts
are typically used to hedge risk as well as speculate on future prices. Forwards and
futures contracts differ in a few ways. Futures are standardized contracts that trade
on exchanges whereas forwards are non-standard and trade OTC. (The futures
markets can seem daunting, but these explanations and strategies will help you trade
like a pro.

The Bottom Line

The proliferation of strategies and available investments has complicated investing.
Investors who are looking to protect or take on risk in a portfolio can employ a
strategy of being long or short underlying assets while using derivatives to hedge,
speculate or increase leverage. There is a burgeoning basket of derivatives to choose
from, but the key to making a sound investment is to fully understand the risks
-counterparty, underlying asset, price and expiration - associated with the derivative.
The use of a derivative only makes sense if the investor is fully aware of the risks and
understands the impact of the investment within a portfolio strategy.
 How Companies Use Derivatives To Hedge Risk

by David Harper,CFA, FRM (Contact Author | Biography)

If you are considering a stock investment and you read that the company uses derivatives to
hedge some risk, should you be concerned or reassured? Warren Buffett's stand is famous: he
has attacked all derivatives, saying he and his company "view them as time bombs, both for
the parties that deal in them and the economic system" (2003 Berkshire Hathaway Annual
Report). On the other hand, the trading volume of derivatives has escalated rapidly, and non-
financial companies continue to purchase and trade them in ever-greater numbers.

To help you evaluate a company's use of derivatives for hedging risk, we'll look at the three
most common ways to use derivatives for hedging. (To get a better understanding of hedging
and how it works, seeA Beginner's Guide To Hedging.)

Foreign-Exchange Risks
One of the more common corporate uses of derivatives is for hedging foreign-currency risk,
or foreign-exchange risk, which is the risk that a change in currency exchange rates
will adversely impact business results.

Let's consider an example of foreign-currency risk with ACME Corporation, a hypothetical

U.S.-based company that sells widgets in Germany. During the year, ACME Corp sells 100
widgets, each priced at 10 euros. Therefore, our constant assumption is that ACME sells 1,000
euros worth of widgets:
When the dollar-per-euro exchange rate increases from $1.33 to $1.50 to $1.75, it takes more
dollars to buy one euro, or one euro translates into more dollars, meaning the dollar is
depreciating or weakening. As the dollar depreciates, the same number of widgets sold
translates into greater sales in dollar terms. This demonstrates how a weakening dollar is not
all bad: it can boost export sales of U.S. companies. (Alternatively, ACME could reduce its
prices abroad, which, because of the depreciating dollar, would not hurt dollar sales; this is
another approach available to a U.S. exporter when the dollar is depreciating.)

The above example illustrates the "good news" event that can occur when the dollar
depreciates, but a "bad news" event happens if the dollar appreciates and export sales end
up being less. In the above example, we made a couple of very important simplifying
assumptions that affect whether the dollar depreciation is a good or bad event:

(1) We assumed that ACME Corp. manufactures its product in the U.S. and therefore incurs
its inventory or production costs in dollars. If instead ACME manufactured its German widgets
in Germany, production costs would be incurred in euros. So even if dollar sales increase due
to depreciation in the dollar, production costs will go up too! This effect on both sales and
costs is called a natural hedge: the economics of the business provide their own hedge
mechanism. In such a case, the higher export sales (resulting when the euro is translated
into dollars) are likely to be mitigated by higher production costs.

(2) We also assumed that all other things are equal, and often they are not. For example, we
ignored any secondary effects of inflation and whether ACME can adjust its prices.

Even after natural hedges and secondary effects, most multinational corporations are
exposed to some form of foreign-currency risk.

Now let's illustrate a simple hedge that a company like ACME might use. To minimize the
effects of any USD/EUR exchange rates, ACME purchases 800 foreign-exchange futures
contracts against the USD/EUR exchange rate. The value of the futures contracts will not, in
practice, correspond exactly on a 1:1 basis with a change in the current exchange rate (that
is, the futures rate won't change exactly with the spot rate), but we will assume it does
anyway. Each futures contract has a value equal to the "gain" above the $1.33 USD/EUR rate.
(Only because ACME took this side of the futures position, somebody - the counter-party - will
take the opposite position):
In this example, the futures contract is a separate transaction; but it is designed to have an
inverse relationship with the currency exchange impact, so it is a decent hedge. Of course,
it's not a free lunch: if the dollar were to weaken instead, then the increased export sales are
mitigated (partially offset) by losses on the futures contracts.

Hedging Interest-Rate Risk

Companies can hedge interest-rate risk in various ways. Consider a company that expects to
sell a division in one year and at that time to receive a cash windfall that it wants to "park" in
a good risk-free investment. If the company strongly believes that interest rates will drop
between now and then, it could purchase (or 'take a long position on') a Treasury futures
contract. The company is effectively locking in the future interest rate.

Here is a different example of a perfect interest-rate hedge used by Johnson Controls

(NYSE:JCI), as noted in its 2004 annual report:
Fair Value Hedges - The Company [JCI] had two interest rate swaps outstanding
at September 30, 2004, designated as a hedge of the fair value of a portion of fixed-rate
bonds…The change in fair value of the swaps exactly offsets the change in fair value of the
hedged debt, with no net impact on earnings. (JCI 10K, 11/30/04 Notes to Financial
Statements)

Johnson Controls is using an interest rate swap. Before it entered into the swap, it was paying
a variable interest rate on some of its bonds. (For example, a common arrangement would be
to pay LIBOR plus something and to reset the rate every six months). We can illustrate these
variable rate payments with a down-bar chart:

Now let's look at the impact of the swap, illustrated below. The swap requires JCI to pay a
fixed rate of interest while receiving floating-rate payments. The received floating-rate
payments (shown in the upper half of the chart below) are used to pay the pre-existing
floating-rate debt.
JCI is then left only with the floating-rate debt, and has therefore managed to convert a
variable-rate obligation into a fixed-rate obligation with the addition of a derivative. And
again, note the annual report implies JCI has a "perfect hedge": The variable-rate coupons
that JCI received exactly compensates for the company's variable-rate obligations. (To get a
better understanding of what swaps are and how they work, see An Introduction To Swaps.)

Commodity or Product Input Hedge

Companies that depend heavily on raw-material inputs or commodities are sensitive,
sometimes significantly, to the price change of the inputs. Airlines, for example, consume lots
of jet fuel. Historically, most airlines have given a great deal of consideration to hedging
against crude-oil price increases - although at the start of 2004 one major airline mistakenly
settled (eliminating) all of its crude-oil hedges: a costly decision ahead of the surge in oil
prices.

Monsanto (NYSE:MON) produces agricultural products, herbicides and biotech-related

products. It uses futures contracts to hedge against the price increase of soybean and corn
inventory:

Changes in Commodity Prices: Monsanto uses futures contracts to protect itself against
commodity price increases… these contracts hedge the committed or future purchases of,
and the carrying value of payables to growers for soybean and corn inventories. A 10 percent
decrease in the prices would have a negative effect on the fair value of those futures of $10
million for soybeans and $5 million for corn. We also use natural-gas swaps to manage
energy input costs. A 10 percent decrease in price of gas would have a negative effect on the
fair value of the swaps of $1 million. (Monsanto 10K, 11/04/04 Notes to Financial Statements)

Conclusion
We have reviewed three of the most popular types of corporate hedging with derivatives.
There are many other derivative uses, and new types are being invented. For example,
companies can hedge their weather risk to compensate them for extra cost of an
unexpectedly hot or cold season. The derivatives we have reviewed are not generally
speculative for the company. They help to protect the company from unanticipated events:
adverse foreign-exchange or interest-rate movements and unexpected increases in input
costs. The investor on the other side of the derivative transaction is the speculator. However,
in no case are these derivatives free. Even if, for example, the company is surprised with a
good-news event like a favourable interest-rate move, the company (because it had to pay
for the derivatives) receives less on a net basis than it would have without the hedge