If as a student you have taken a loan of $100,000 @6% p.a. for 5 years, but you are worried about the interest rate fluctuation. And, supposedly before the completion of 5 years the interest rate goes down to 3%, while you are still paying a higher rate @6%. What will you do?
All you can do is to find someone who will insure this so that the rate will stay constant @6% and he will be responsible for any loss caused by the rate fluctuation, although for some premium.
Even though you are a finance fanatic it is very important to learn about derivatives for the FRM course, as you would learn different types and usages of derivative instruments by a financial risk manager. Also, Derivatives offers 30% weightage in FRM 1 exam and you will face 30 questions from derivatives.
Derivatives in brief:
If you have ever tried your luck in markets, most probably you must have come across the word “derivatives”. To some, these jargons might appear to be mundane. However, some of us feel lost in some financial gatherings /conversations, not sure of what these jargons are and how these might affect us. Also, many a times in newspapers you might have come across articles on the famous 2008 financial crisis, where they dived into the world of credit default swaps derivatives etc. Sounds familiar?
Ever wondered, what these really are or what do they mean to an investor? You can read through this brief explanation on derivatives to learn more about them:
Assume yourself to be a farmer in California, US. The harvesting season is near and you are really excited about the bumper harvests you are expecting this year. However, at the same time you are worried because you are not quite sure if you will be adequately compensated by the Californian government for your crops. So, you would want to remove this element of uncertainty, as to whether you will get the price per quintal as demanded by you. Then how can you overcome this problem/uncertainty over crop prices?
Yes, as you guessed it right, you can rightly make use of “Derivatives” to lock in the prices even before the harvesting season. This implies that you can negotiate the prices with the government/buyers even before delivering the actual crops and arrive at a fixed price at which you will sell the crops after the harvesting is over. This is equivalent to saying that you have entered into a forward agreement with the crop buyers according to which you will sell your crops to them at a predetermined price at some point in future.
You are now not worried of getting a price much less than what you had anticipated while sowing the seeds. On the same lines there are futures contracts which are almost similar to forwards except that futures are standardized instruments and are traded on exchanges. Forward contracts enjoy the element of flexibility embedded in them. In forwards, both the parties (i.e. sellers and buyers) can discuss or negotiate the terms of the contract i.e. the price to be paid, the delivery or settlement procedure etc.
Not only these, there can be numerous types of derivatives prevalent in the market. For example – Consider the case of Southwest Airlines. They typically enter into futures contracts with the oil companies. Using these contracts, they fix in the price of oil at say $20/barrel (when the price is low) when actually the cost of oil has risen to $100/barrel.
Last but not the least; you should be aware of options of derivative contracts too. As the name implies, options allow us to exercise our choice/option to buy an asset/commodity at a fixed, predetermined price in the future. You can exercise your option, only, if you think you will make profits from the transaction. If, however, there is a slight chance of suffering a loss, you can immediately take a decision of not exercising the contract.
A call option allows an investor to buy an asset at a fixed price in future. This is irrespective of the actual price at which the asset will be traded in future. The idea behind an option is present in many of the everyday situations.
For example, you found a house that you'd love to purchase. Unfortunately, you don’t have cash to buy it for another six months. You talk to the owner and negotiate a deal that gives you an option to buy the house in six months for a price of $300,000. The owner agrees, but for this option, you pay a price of $2,000.This means that you would have to pay $302,000 to buy the house from its owner. So, after six months even if the current market price rises from $300,000 to $500,000, you would not have to pay the increased price, as you had a deal with the owner.
So effectively, by paying an option premium of only $2000, you are locking the commodity (here, the house) for yourself at a fixed price. In case, if the price falls down to $100,000, you would most likely not pay $300,000 for a house that is presently worth less. That means you will simply let the option of buying the house expire instead of paying more than the market price. On similar lines, there is a put option which allows you an option to sell an asset (short) for a fixed price in future.