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What are derivatives?
?? á???ê￥2?ê? Dr Joseph Lim??A derivative is a financial instrument whose value is derived (hence the name) from an underlying asset. For example, the value of a warrant depends on the value of the underlying share (or "mother share"). Or the value of a gold futures contract is derived from the current price of gold. Derivatives come in two forms: options and futures.??There are two types of options: a call and a put. A call gives the holder a right, but not the obligation, to purchase a share at a fixed price, known as the exercise price (Warrants and TSRs are essentially calls). A put gives the holder the right, but not the obligation, to tender a share and receive, in return, a fixed price.??If you think that the share price of a company is going torise, one way to profit from this is to buy its shares. However, if you are wrong, and the share price falls instead, you would have suffered a loss. The size of the loss would depend on how much the price falls, something difficult to know ahead of time. Such an uncertainty may prevent you from acting on your hunch.??However, if from the start you know exactly how much you stand to lose if your hunch is wrong, you may be emboldened to act. This is possible if you buy a call with the exercise price equal to the current share price. The maximum amount you can lose is the price of the call.??Why? Remember that a call gives you the right, but not theobligation, to purchase a share. If the share price rises above the exercise price, you would exercise the option. You pay the exercise price and receive a share which is worth more.??However, if the share price falls below the exercise price, you do nothing. The maximum amount you can lose is the call price, regardless of how much the share price has fallen.??What about the situation where you want to profit from a possible fall in the share price of a company? One way is to sell short its shares. The other is to buy a put with anexercise price equal to the current share price. If the price indeed falls, you would buy a share, tender it with the put and receive the exercise price, placing you in a similar situation had you sold short the shares. Should theprice rise instead, your loss would be limited to the price of the put. However, someone who sells short the shares mayend up with very substantial losses if the price rises by a large amount.??The price of an option depends on five factors: the share price, the exercise price, the time to expiration, the interest rate and the volatility of the underlying share price.??The higher the share price or the lower the exercise pricethe more valuable a call. This is because the call gives usthe right to buy the share at a fixed price.??Options have lives of up to one year (