The
Economic Freedom
Network

Appendix C
Derivatives and index funds

[Previous] [Contents] [Next]

Derivatives

A derivative is a financial instrument that derives its value, in whole or in part, from some underlying asset. It is essentially a contract whose returns are linked to the price movements of an underlying asset, such as a commodity, a share in a public company, an interest rate, or a currency.

The critical distinction between the derivative and the underlying asset is that the derivative is an intangible asset whose value is derived indirectly while the underlying asset has tangible, inherent value. For example, the difference between derivatives on securities and the securities themselves is that shares are assets, "physical pieces" of a company, while derivatives are contracts based on the securities.

Derivatives enable investors to control foreign assets without actually owning the asset. For example, an investor who purchases certain types of derivatives to mirror the Dow Jones Industrial Average or the Standard & Poor 500 Index can effectively match the return performance of the underlying asset without actually owning the asset.

It is important to note, however, that the use of derivatives is extremely complex and based on a host of sophisticated mathematical formulations.

Types of Derivatives

There are many types of assets that are classified as derivatives. The unifying concept used in classifying derivatives is that all these instruments are contracts that derive their value either in part or in whole from the underlying asset on which they are based. Some examples of the more common derivatives are set out below.

Exchange Traded Options

Options that trade on major stock exchanges, like the Chicago Board Options Exchange, are regulated and standardized. These are called "exchange traded options." Individuals can purchase these options on, for example, specific stocks much as they would purchase the stocks themselves.

An option contract gives the purchaser the right but not the obligation to buy or sell a certain quantity of a specific asset (e.g., security, currency, debt instrument, commodity, or stock index) at a predetermined price, called the strike or exercise price.

The price at which the option contract trades is called the premium. It is paid by the purchaser to the seller (writer) of the option. The option seller retains the premium whether or not the option is exercised.

A call option gives the owner the right (not the obligation) to buy an asset. Alternatively, a put option gives the purchaser the right (not the obligation) to sell an asset. The purchase or sale of the asset occurs either on a specific future date (European option) or by a certain date in the future (American option).

An option holder (buyer) is not obligated to exercise the option (sell the asset or take delivery of it). If the option is not exercised or sold by the holder before expiration, the option privilege expires and the contract becomes void.

The potential loss to the buyer of an option can be no greater than the initial premium paid for the option, regardless of how the underlying asset's price changes. This is what allows the buyer to control the amount of risk assumed. The option writer or seller, in exchange for the premium received from the buyer, assumes the risk of making delivery of the asset if the contract is exercised, where this could lead to significant losses depending how the asset's price has changed.

Similar to stocks, options can be used to take a position on the market in order to make a profit on an upward or downward movement in the market. Buying an option gives the investor the ability to predetermine and therefore limit risk; that is, the "downside risk" is limited, whereas the potential gain is not (see figures C1 and C2). Writing an option, conversely, exposes the investor to significant downside risk, unless the underlying asset is also owned.

Figure_C1

Figure_C2

Equity Options

For equity options, one option contract is typically written based on 100 shares of a specific common stock. Unlike stocks, rights, or warrants, equity options are not securities issued by the underlying company. The owner of an equity option owns an agreement giving the right, but not the obligation, to buy or sell shares; more precisely the investor does not own any underlying asset (stock).

Unlike shares, there is no fixed number of equity options outstanding: the number of options in existence depends on the number of writers and buyers of options. An option based on a stock is inherently more risky than the stock itself. That is, while an option mirrors the performance of a stock, the investor owns nothing tangible and can lose the premium, or worse if they "bet" wrong.

The market for writing or buying new options is called the primary market. There is also a secondary options market where previously written options are traded. A central clearing corporation (one each in Canada and the United States) has the function, among other things, of matching all buy and sell orders on the secondary market so that at any time there is a corresponding number of options sold by writers for all options held by buyers. If an option is exercised, commission is payable on the underlying asset by both the option holder and the writer, in addition to the original commission paid by both parties when an option is written.

Buying an equity put option

Refer to figure C2, Buying a Put Option, for this discussion. In February, when ABC company's common shares traded at $30, an investor who owned 100 ABC common shares (purchased some time before at $15 per share) buys one "ABC July 30 put at 2" (30 is the exercise price of the option and 2 is the premium). Although this investor views ABC Company as a long-term investment and so does not want to sell the stock right now, they are "bearish" about the stock market over the short-term. That is, they are concerned that the market price of ABC will fall substantially in the short-term. Purchasing one ABC July 30 put (100 common shares of ABC) at 2 , provides the ABC investor with short-term protection against a substantial decline in the value of ABC Company common shares. Purchasing the ABC July 30 put guarantees the investor pre-tax profit of $12.50 per ABC common share (less applicable commission) until the put expires at a specific date in July.

The guaranteed pre-tax profit is calculated as follows: $30 (sale price of ABC if the put buyer exercises the ABC put and sells 100 ABC to the put seller) less $2.50 (the premium cost to buy the ABC put) less $15 (the original price paid for the ABC common shares) per share (multiply by 100 to get the total value of the put option).

Now assume that, before the ABC July 30 put expires, the market price of ABC falls below $27.50 as part of a general stock market decline. The ABC investor decides to take the guaranteed pre-tax profit of $12.50 per share. Note that $27.50 is the break-even point for this put option whereby the purchaser of the option completely re-coups his costs. If the price of ABC is greater than this, the investor is better off selling the shares on the market as they will bring more than the $12.50 guaranteed from exercising the option.

On the other side, since the ABC put buyer decides to exercise the put, the ABC put seller (or writer) has to buy the shares from the put buyer for the agreed $30, even though the market price of the shares is less than $30. In this case, the put buyer makes money; the put seller loses money.

In selling the ABC July 30 put, the put writer (seller) hoped the market price of ABC would either increase or remain at the $30 level, so that it would not be in the put buyer's interest to exercise the put. If the ABC put holder sells the put or lets it expire unexercised, the ABC put writer is not affected and retains the premium ($250).

The potential loss to the put buyer is no more than the premium ($250) and the potential gain depends on how far the price of ABC common stock falls. This allows the put buyer to make certain realizing at least a certain price for the stocks and, thus, can be useful insurance when an investor believes the price of ABC common stock will fall.

The value of an options contract is related not just to whether the investor takes delivery of shares or sells them but also to how the market moves. That is, once having bought or written a put, it is valuable on the secondary market, depending on how the price of the underlying asset moves in relation to the exercise price. The further from the expiry date of the option contract, the more valuable the option is because there is a greater length of time for the price of the underlying asset to move favourably. As the expiry date gets closer, the option contract declines in value because there is less uncertainty related to what the market price of the asset will be on the expiry date.

Non-Equity Options

Besides equity options contracts, there are a number of non-equity options such as gold and silver, other commodities, currencies, debt instruments (e.g., T-bills, T-bonds, T-notes, and other bonds), stock indexes, and interest-rate options.

Currency options have an important "hedging" role in reducing currency or foreign exchange risk for exporters and importers. Currency options give Canadian export-oriented corporations and individuals that hold foreign currency denominated assets the opportunity to hedge against foreign currency fluctuations as well as offering speculators the potential for capital gains.

Futures

Futures contracts are the other major type of derivative. Futures contracts can be written on agricultural products, metals, certain foreign currencies, and some financial instruments such as interest rates and stock indices. For example, commodity futures contracts are commitments to deliver or take delivery of a specified quantity and quality of a commodity during a specified future month at an agreed upon price (determined in a commodity exchange).

In commodity futures transactions, no immediate transfer of ownership, or in most cases, delivery of the actual commodity is involved. In other words, you can buy and sell commodities in a futures market whether or not you own the particular commodity. Most futures contract buyers and sellers close out their contracts (by selling or buying) prior to the delivery month so that physical deliveries are rare.

Participants in the futures market are divided between hedgers and speculators. Hedgers are corporations or individuals who deal in the physical commodities or financial instruments and take on futures contracts to protect their holdings by securing their prices. These investors use the futures market as a form of insurance-with the objective not of making money but of not losing it.

Speculators do not deal in physical commodities. They use their risk capital to try to take advantage of price fluctuations between the futures market and current prices. Unlike hedgers, the goal of speculators is to buy and sell futures contracts in an attempt to make profits. Speculation is inherently a risky enterprise. The fast moving futures markets can result in large losses as well as the opportunity of making a large amount of money.

Forward Contracts

A forward contract obligates the holder to take delivery, and the writer to make delivery, of an underlying asset at a specified price on a future date. A forward contract is identical to a futures contract in that both constitute an obligation to take, or make delivery of an underlying asset at a future date. Technically, a futures contract is equivalent to a forward contract that is settled daily.

Other Derivatives

Other derivatives include: interest rate caps, floors, collars, and swaps. An interest rate cap, places an upper limit on the interest cost to the purchaser of the contract, by formulating a portfolio of (European) call options on the relevant interest rate index, or equivalently, a portfolio of put options on discount bonds. An interest rate floor places a lower limit on the interest rate to be charged; by creating a portfolio of put options on interest rates or call options on discount bonds. Collars specify both the upper and lower limits for the rate that will be charged. A collar is a combination of a long position in a cap and a short position in a floor. Swaps represent a series of forward transactions in which the counter parties agree to buy and sell a stream of cash flows on a notional principal amount over a predetermined length of time. The cash flows exchanged in a swap can be based on fixed or floating interest rates and on the same or different currencies. Interest rate swaps involve only the exchange of interest payments, while currency swaps also entail the exchange of principal amounts.

Index Funds

Index funds are based on portfolios of securities or bonds that are purchased in the same proportion as they are weighted on an exchange such as the Toronto Stock Exchange 300 Composite Index or the Dow Jones Industrial Average. Investors do not actually purchase an amount of each type of stock or bond included in the index. Instead, investors hold shares in a fund or other intermediary that holds shares of each of these companies, weighted according to how the index weights each company's' shares.

Index funds are intended to mirror movements in a broad market. Therefore, if an individual has purchased a broad index, such as the Dow Jones Industrial or the TSE 300 Composite Index, when the market is up, a Dow Jones or TSE 300 index fund will be up; when the market is down, the index fund will be down.

There are two major advantages of index funds. The first is broad diversification, since indices typically contain stock or bonds from a wide range of sectors or countries. Traditional stock or bond investing tries to "beat the market" where as index investing "buys the market." By emulating the performance of a particular market index such as the Toronto Stock Exchange 300 Composite Index or Standard & Poor's 500 Total Return Index in the United States, investors can reduce their market risk.

The second advantage, is lower management expense ratios (MERs). Index funds are "passively managed": the investment manager does not try to outperform the market but rather purchases those shares in quantities pre-determined by the index, in effect becoming the market. There is no decision-making as to what stocks to purchase and in what proportion.

The movement toward investment in index funds in the past few years is based on the assumption that globalization and unification of markets is causing markets to become increasingly efficient and hence correlated. The more efficient a market, the more difficult it is for a fund manager to add value through the search, purchase, and sale of mis-priced assets. Portfolio theory has proven that one of the best means of maximizing return and minimizing risk is to own the market itself. Purchasing an index fund effectively allows individual investors to purchase the market, whether it is the TSE 300 Composite Index, the Dow Jones Industrial Average, the Standard & Poor 500 Total Return Index, or the Morgan Stanley Capital Investment International Stock Fund.