What are derivatives? Let me take you through a short and easy to understand story where the relationship between a stock portfolio and financial derivatives is explained.

⏱️TIMESTAMPS⏱️
00:00 Introduction to financial derivatives
00:48 Call options
02:36 Put options
04:23 Forwards and futures
05:27 Swap contract
06:07 Financial derivative definition

Let’s take a look at the share price of a fictional company called Toy Giraffe Inc. The share price has been going up and down in the $80 to $100 range over the past years. Meet John. He recently bought 1000 shares in Toy Giraffe Inc, at $100 per share. He expects the share price to stay pretty much the same in the future, so no specific expectations on his side of making a return from the share price rising, but he is really excited about the expected annual dividend.
When we start discussing financial #derivatives, the stocks that John bought are called the underlying asset.
An example of a derivative is a call option. John is approached by Jane, his stock broker, with an offer. She offers $2 per share for her to receive the right to buy John’s shares at $120 per share within 6 months. If John and Jane agree on that transaction, then they have just entered into a derivative contract. The value of the call option depends on (“is derived from”) the value of the shares during the next six months.
If the share price stays at $100 until the expiration date, then Jane will not exercise her call option, as she has the right but not the obligation to do so. In this scenario, John makes $2 per share on selling the call option to Jane, and Jane loses $2 per share by having bought an option that she is not using.
If the share price goes up to $130, then Jane will exercise her call option, as it gives her the right to buy shares from John as $120 while in the open market she can then sell them for $130. Her payoff is $8 in total: $10 gain on the share (the difference between $120 and $130), minus the $2 cost of the option. John’s payoff is also positive: he gained $20 when the share rose from $100 to $120, does not benefit from the further increase of the share price as the shares are now transferred to Jane, but makes an additional $2 from having sold the call option to Jane. By selling a call option to Jane, he has capped (put a limit on) his potential gain from a rising share price.
Call options provide the right to buy, put options provide the right to sell. John is worried that the share price of Toy Giraffe Inc might drop. Not so worried that he immediately sells his entire portfolio, but looking to get some “insurance” against a very big drop in the share price. Jane has a solution. For $4 per share, she will give him the right to sell his shares to her at $80 per share within 6 months. If John and Jane agree on that transaction, then they have just entered into a derivative contract. The value of the put option depends on (“is derived from”) the value of the shares during the next six months.
There are many other types of financial derivatives, that fall into the category of forwards or futures. A forward contract is an agreement between two parties, a buyer and a seller, to purchase or sell something at a later date at an agreed price. Futures are standardized forward contracts that trade on organized exchanges. To illustrate forwards and futures, we could look at the expected annual dividend on Toy Giraffe Inc shares. One year from now, the company is expected to pay $4 per share in cash dividend. This is not an absolute guarantee, it is an estimate based on historical dividend payments and expectations about future free cash flow of the company. Jane has an offer for John on this: $3 right now in return for the $4 dividend that is expected to be paid next year. The 25% discount covers the time value of money as well as the uncertainty around the dividend payout.
A financial derivative is any security whose value is derived from the value of another (underlying) asset. We discussed options, forwards, futures and swaps in this video.
Philip de Vroe (The Finance Storyteller) aims to make accounting, finance and investing enjoyable and easier to understand. Learn the business and accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better investing decisions. Philip delivers #financetraining in various formats: YouTube videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!

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