Learn about Derivatives in Capital Markets

Securities traded in the Capital Markets come in many different forms. A Derivative is a type of security that literally derives its value from another security. Options and Futures are the two most common Derivatives. However, there are important differences between these two securities.

Options are the right to buy or sell another security at a particular point in the future. Suppose a stock is currently selling for $50 and an investor pays $5 for an Option to buy one share of the stock for $60 in one year. When the option matures in one year, the stock is selling for $70. By exercising the Option, the investor stands to make a profit of $5. Essentially, the investor buys something for $60 that is worth $70. After subtracting the $5 which it cost the investor to buy the Option, the residual, realized value is $5. Were the stock selling for $40 at the Option’s maturity, the investor would simply not exercise the Option having lost only the $5 it cost to buy the Option.

Sometimes Options are hidden. A warranty is a kind of Option that allows a purchaser the option to return a purchase and get her money back should the product no longer appeal to the purchaser for some reason. Often, warranties have stipulations (limitations) which function like the stipulations restricting the investor to certain conditions when exercising an Option.

A Future is a type of Forward Contract traded on a futures market. Forward Contracts are agreements to buy and sell a security in the future for a stated price. Unlike Options, a Forward Contract is an obligation to buy or sell the underlying security. Futures are often traded on commodities such as wheat, coffee, and gold but are also traded on stocks, bonds, and foreign currency. The question is: why bother buying futures? Why not just buy or sell the underlying security now or in the future?

Suppose that you will need wheat in the future but that wheat hasn’t been harvested yet. By buying a future now, you have secured the price you will pay for the wheat thereby eliminating the risk that wheat prices will rise in the future. Of course if wheat prices fall, you are obligated to pay the higher price as stipulated on the Futures Contract.

Futures Contracts have the benefit of allowing the producers and buyers of commodities to concentrate on their respective businesses without having to constantly worry about future prices which can fluctuate greatly. Since agricultural products such as wheat are subject to weather conditions, insects, etc., Futures Contracts help alleviate the uncertainty of agricultural yields. And as supply and demand dictate, high demand and low supply can make for huge price fluctuations. Private Futures Contracts can be beneficial to both buyers and sellers but only public Futures are traded in Capital Markets.

The main difference between Options and Futures in Capital Markets is that Options are rights and Futures are obligations to buy or sell. Each serves an important function in valuing the underlying asset. What’s important is to remember that derivatives do not grant ownership of the underlying asset until either an Option is exercised or a Future matures.