Derivative

What are Derivatives?

It had always been one of the toughest topics while I was in my twelfth standard. But I guess this topic is much different. Here we talk about financial derivatives.

Derivative is simply a thing which derives its value out of something else.

Let us suppose I have a piece of land in Chennai. Now the price of the land would depend on a lot of things situated around it.
If a huge mall, a residential complex and an IT SEZ surround my piece of well developed land the market price of the piece of land would be high.
If the same piece of land had been ill developed surrounded by Garbage dumping ground it would have been available for cheap.

So the price of the land is a derivative of the development in and around it. That is, when the price of local area increases the price of my land increases.

Here the underlying asset is the local area encompassing the land.

What are Swaps?

Now I get into lease contract with someone who has Rs. 10 lac with him. I tell him it would be a 10 year lease.
Since I want to avoid the risk of fluctuating prices I ask lessee to pay me Rs. 1 lac every year as part of the lease instead of yearly changing market related rent.

So I have transferred the risk of the price changes with a fixed payoff from the lessee.
The lessee expects the prices of properties to appreciate in the future and intends to make gains from yearly assumed rising prices from the use of the property.

This is called a swap in positions. How?

Instead of me charging the yearly changing market related rent (variable / flexible) I decide to take a fixed amount of Rs. 1 lac. (Fixed) i.e I have swapped my position from flexible to fixed.

Now the lessee who had a fixed amount Rs. 10 lac with him (Fixed) has shifted his position to flexible on the assumption that the trend of property rentals is upwards.

What are options?

Options are nothing but a choice offered to the buyer of the option.

If Iessee requests inclusion of a clause in the lease that we shall terminate the lease if the market rentals decrease by more than 10% from the current Rs. 1lac, at the end of 5 years. This is called a Call option with the lessee.

Why Call?

Call because lessee has been given the right to foreclose/ call back/buy back our existing agreed position. I am the call writer here.

I tell him to provide such a provision I would charge an extra sum of Rs. 25000 in the first year. This is the Option price which lessee would have to pay.

I request the lessee in return that I would like an inclusion of clause that we shall terminate the lease if the market rentals increase by more than 20% from the current Rs. 1 lac, at the end of 5 years. This is called put option.

Why Put?

Put because the lessee has offered the right to me to foreclose/ give back/ our existing agreed position. lessee is the put writer here.

Lessee tells me that such a provision would amount to a deduction of Rs. 15000 (Put option price) from the Call Option price of Rs. 25000.