What Is an Equity Derivative?

An equity derivative is a financial instrument whose value is based on the

equity movements of the underlying asset. For example, a stock option is an
equity derivative, because its value is based on the price movements of the
underlying stock.

Equity derivatives are financial products/instruments whose value is

derived from the increase or decrease in the underlying assets, i.e., equity
stocks or shares in the secondary market.

Equity derivatives are agreements between a buyer and a seller to either

buy or sell the underlying asset in the future at a specific price. They can
either hold the right or the obligation to trade the asset at the expiry of
the contract.

● Underlying assets represent the assets from which derivatives derive

their value.
● Knowing the value of an underlying asset helps traders determine the
appropriate action (buy, sell, or hold) with their derivative.

Investors can use equity derivatives to hedge the risk associated with taking
long or short positions in stocks, or they can use them to speculate on the
price movements of the underlying asset.

● A hedge is a strategy that seeks to limit risk exposures in financial

assets.
● Popular hedging techniques involve taking offsetting positions in
derivatives that correspond to an existing position.
● Other types of hedges can be constructed via other means like
diversification. An example could be investing in both cyclical and
countercyclical stocks.
● Besides protecting an investor from various types of risk, it is believed
that hedging makes the market run more efficiently.
How They are Traded

To trade an equity derivative, the investor needs to be very knowledgeable

about the product and the industry, as derivatives allow an investor to
speculate and make large gains or losses.

Understanding Equity Derivatives

Equity derivatives can act like an insurance policy. The investor receives a
potential payout by paying the cost of the derivative contract, which is referred
to as a premium in the options market. An investor that purchases a stock,
can protect against a loss in share value by purchasing a put option. On the
other hand, an investor that has shorted shares can hedge against an upward
move in the share price by purchasing a call option.

● Short selling occurs when an investor borrows a security and sells it on

the open market, planning to buy it back later for less money.

Why Sell Short?

● The most common reasons for engaging in short selling are speculation
and hedging. A speculator is making a pure price bet that it will decline
in the future. If they are wrong, they will have to buy the shares back
higher, at a loss. Because of the additional risks in short selling due to
the use of margin, it is usually conducted over a smaller time horizon
and is thus more likely to be an activity conducted for speculation.

Equity derivatives can also be used for speculation purposes. For example, a
trader can buy equity options, instead of actual stock, to generate profits from
the underlying asset's price movements. There are two benefits to such a
strategy. First, traders can cut down on costs by purchasing options (which
are cheaper) rather than the actual stock. Second, traders can also hedge
risks by placing put and call options on the stock's price.

Other equity derivatives include stock index futures, equity index swaps, and
convertible bonds.

Why Invest in an Equity Derivative?

One risk associated with an investment is the ownership of the

investment. Equity derivatives allow the investor to buy only into the
performance of the underlying investment without taking ownership of
the company. Hence, the risk of losing money is less compared to owning
the product.

Investment products are beneficial in the long term. However, if an

investor is looking for better returns in the short term, equity derivatives
are the best options. An investor who owns a portfolio with long-term
investments can add equity derivatives to achieve a well-built portfolio
that pays short-term and long-term returns.

Investing in equity derivatives is very tricky and requires the investor to

know as much about the business as possible. It means the investor
needs to undergo training to learn about derivatives trading. By doing so,
the investor can then work better with a financial advisor, as they are
more aware of how their money is being handled and where it is being
invested.

Types of Equity Derivatives

Options

Options give the holder of the option the right, but not the obligation, to
buy (call option) or sell (put option) a particular stock at a given price. The
contract provides information about the given price, which is called the
strike price, the expiration date, and the terms and conditions of the
contract. An options contract is best suited for investors who want to
protect or hedge themselves from increases or decreases in prices in the
future.

Warrants

Just like options, warrants give the holder the right, but not the obligation,
to buy (call warrants) or sell (put warrants) the underlying investment in
the future. The company issues the warrants to the holders of its bonds or
preferred stock as an incentive to buy the issue.

Futures

Futures contracts are traded on the secondary market. In a futures

contract, the buyer agrees to buy the asset on a future date and at a
specific price. Unlike options, in a futures contract, the buyer has an
obligation to buy the asset. In simple terms, the buyer must buy the asset
on the date mentioned on the contract at the specified price.

Forwards
Like a futures contract, a forward contract specifies the future date and
price that the buyer should purchase the underlying asset from the seller.
The only difference is that a forward contract takes place in the private
market and terms are tailored to the parties to the contract.

Convertible bonds

Convertible bonds allow the holder the option to convert the bonds into
shares of the company. Along with the features of the bond (coupon and
maturity date), convertible bonds also come with a conversion rate and
price associated with it. Because of the conversion feature, such types of
bonds pay a lower rate of interest compared to normal bonds.

Swaps

Swaps are derivatives where returns of two different equity stocks are
exchanged between two parties. Apart from equity returns, the exchange
can also be related to floating and fixed interest rates, currencies of
different countries, etc.

Risks Associated With Derivatives

Interest rate risk

An investor expecting the interest rates to rise in the future and enters
into a derivative contract to pay a fixed interest rate in the future can face
a risk of interest rates going down. By paying a fixed rate of interest, they
may be locked into paying more money rather than taking a loan in the
future at a lower rate.

Currency risk

Importers and exporters enter into derivative contracts to hedge

themselves with fluctuating currency rates. The risk associated with this is
if the currency falls or goes in the opposite direction compared to what
the investor is expecting.

Commodity price risk

Commodity derivatives are traded if investors expect the prices of the
underlying asset to go down in the future. The most common type of
commodities derivative traded in the market is the oil futures. The risk
associated here is the price of the commodity going up in the future. This
is because the investor now has to sell the commodity at the specified
price, which is lower compared to the current price that has gone up.

Using Equity Options

Equity options are derived from a single equity security. Investors and traders
can use equity options to take a long or short position in a stock without
actually buying or shorting the stock. This is advantageous because taking a
position with options allows the investor/trader more leverage in that the
amount of capital needed is much less than a similar outright long or short
position on margin. Investors/traders can, therefore, profit more from a price
movement in the underlying stock.

For example, buying 100 shares of a $10 stock costs $1,000. Buying a call
option with a $10 strike price may only cost $0.50, or $50 since one option
controls 100 shares ($0.50 x 100 shares). If the shares move up to $11 the
option is worth at least $1, and the options trader doubles their money. The
stock trader makes $100 (position is now worth $1,100), which is a 10% gain
on the $1,000 they paid. Comparatively, the options trader makes a better
percentage return.

If the underlying stock moves in the wrong direction and the options are out of
the money at the time of their expiration, they become worthless and the
trader loses the premium they paid for the option.

Another popular equity options technique is trading option spreads. Traders

take combinations of long and short option positions, with different strike
prices and expiration dates, for the purpose of extracting profit from the option
premiums with minimal risk.

● A spread option functions as a vanilla option but the underlying is a

price spread rather than a single price.
 ● The price spread used may be the spread between spot and futures
prices (the basis), between interest rates, or between currencies,
among others.
● Spread options typically trade over-the-counter (OTC).
● Vanilla options are financial instruments that enable purchase or sale of
an underlying asset at a pre-determined strike price inside a defined
timeframe.
● Call and put options, which give their owners the right, but not the
obligation to buy or sell an underlying asset, comprise vanilla options.
● Vanilla options can be combined with exotic and binary options to create
custom outcomes.

Leverage
Financial leverage is the use of borrowed money (debt) to finance the
purchase of assets with the expectation that the income or capital gain
from the new asset will exceed the cost of borrowing.

● cost of Borrowing

The interest expense – also known as the cost of borrowing money –

can be classified into the following two types:

#1 Simple Interest

This type of interest is calculated on the original or principal amount

of loan. The formula for calculating simple interest is:

For example, if the simple interest rate is 5% on a loan of $1,000 for

a duration of 4 years, the total simple interest will come out to be:
5% x $1,000 x 4 = $200.

#2 Compound Interest

Compound interest is calculated not just on the basis of the principal

amount but also on the accumulated interest of previous periods.
 This is the reason why it is also called “interest on interest.” The
formula for compound interest is as follows:

Where:

● P = Principal amount
● i = Annual interest rate
● n = Number of compounding periods for a year

Unlike simple interest, the compound interest amount will not be

the same for all years because it takes into consideration the
accumulated interest of previous periods as well.

In most cases, the provider of the debt will put a limit on how much risk it
is ready to take and indicate a limit on the extent of the leverage it will
allow. In the case of asset-backed lending, the financial provider uses the
assets as collateral until the borrower repays the loan. In the case of a
cash flow loan, the general creditworthiness of the company is used to
back the loan.

● In lending agreements, collateral is a borrower's pledge of specific property to a lender, to

secure repayment of a loan. The collateral serves as a lender's protection against a
borrower's default and so can be used to offset the loan if the borrower fails to pay the
principal and interest satisfactorily under the terms of the lending agreement.

This guide will outline how financial leverage works, how it’s measured,
and the risks associated with using it.

How Financial Leverage Works

When purchasing assets, three options are available to the company for
financing: using equity, debt, and leases. Apart from equity, the rest of the
options incur fixed costs that are lower than the income that the company
expects to earn from the asset. In this case, we assume that the company
uses debt to finance asset acquisition.

Example

Assume that Company X wants to acquire an asset that costs $100,000.

The company can either use equity or debt financing. If the company opts
for the first option, it will own 100% of the asset, and there will be no
interest payments. If the asset appreciates in value by 30%, the asset’s
value will increase to $130,000 and the company will earn a profit of
$30,000. Similarly, if the asset depreciates by 30%, the asset will be valued
at $70,000 and the company will incur a loss of $30,000.

Alternatively, the company may go with the second option and finance the
asset using 50% common stock and 50% debt. If the asset appreciates by
30%, the asset will be valued at $130,000. It means that if the company
pays back the debt of $50,000, it will have $80,000 remaining, which
translates into a profit of $30,000. Similarly, if the asset depreciates by
30%, the asset will be valued at $70,000. This means that after paying the
debt of $50,000, the company will remain with $20,000 which translates to
a loss of $30,000 ($50,000 – $20,000).

How Financial Leverage is Measured

Debt-to-Equity Ratio

The debt-to-equity ratio is used to determine the amount of financial

leverage of an entity, and it shows the proportion of debt to the
company’s equity. It helps the company’s management, lenders,
shareholders, and other stakeholders understand the level of risk in the
company’s capital structure. It shows the likelihood of the borrowing
entity facing difficulties in meeting its debt obligations or if its levels of
leverage are at healthy levels. The debt-to-equity ratio is calculated as
follows:

Total debt, in this case, refers to the company’s current liabilities (debts
that the company intends to pay within one year or less) and long-term
liabilities (debts with a maturity of more than one year).

Equity refers to the shareholder’s equity (the amount that shareholders

have invested in the company) plus the amount of retained earnings (the
amount that the company retained from its profits).

Companies in the manufacturing sector typically report a higher debt to

equity ratio than companies in the service industry, reflecting the higher
amount of the former’s investment in machinery and other assets.
Usually, the ratio exceeds the US average debt to equity ratio of 54.62%.

Other Leverage Ratios

Other common leverage ratios used to measure financial leverage include:

● Debt to Capital Ratio

● Debt to EBITDA Ratio
● Interest Coverage Ratio

While the Debt to Equity Ratio is the most commonly used leverage ratio,
the above three ratios are also used frequently in corporate finance to
measure a company’s leverage.

Risks of Financial Leverage

Although financial leverage may result in enhanced earnings for a

company, it may also result in disproportionate losses. Losses may occur
when the interest expense payments for the asset overwhelm the
borrower because the returns from the asset are not sufficient. This may
occur when the asset declines in value or interest rates rise to
unmanageable levels.

Volatility of Stock Price

Increased amounts of financial leverage may result in large swings in

company profits. As a result, the company’s stock price will rise and fall
more frequently, and it will hinder the proper accounting of stock options
owned by the company employees. Increased stock prices will mean that
the company will pay higher interest to the shareholders.

Bankruptcy

In a business where there are low barriers to entry, revenues and profits
are more likely to fluctuate than in a business with high barriers to entry.
The fluctuations in revenues may easily push a company into bankruptcy
since it will be unable to meet its rising debt obligations and pay its
operating expenses. With looming unpaid debts, creditors may file a case
at the bankruptcy court to have the business assets auctioned in order to
retrieve their owed debts.
Reduced Access to More Debts

When lending out money to companies, financial providers assess the

firm’s level of financial leverage. For companies with a high debt-to-equity
ratio, lenders are less likely to advance additional funds since there is a
higher risk of default. However, if the lenders agree to advance funds to a
highly-leveraged firm, it will lend out at a higher interest rate that is
sufficient to compensate for the higher risk of default.

Operating Leverage

Operating leverage is defined as the ratio of fixed costs to variable costs

incurred by a company in a specific period. If the fixed costs exceed the
amount of variable costs, a company is considered to have high operating
leverage. Such a firm is sensitive to changes in sales volume and the
volatility may affect the firm’s EBIT and returns on invested capital.

High operating leverage is common in capital-intensive firms such as

manufacturing firms since they require a huge number of machines to
manufacture their products. Regardless of whether the company makes
sales or not, the company needs to pay fixed costs such as depreciation
on equipment, overhead on manufacturing plants, and maintenance
costs.

Credit Derivative
A credit derivative is a financial contract that allows parties to minimize their
exposure to credit risk. Credit derivatives consist of a privately held,
negotiable bilateral contract traded over-the-counter (OTC) between two
parties in a creditor/debtor relationship. These allow the creditor to effectively
transfer some or all of the risk of a debtor defaulting to a third party. This third
party accepts the risk in return for payment, known as the premium.

● A bilateral contract is the most common type of binding agreement,

which involves concessions or obligations owed by both sides of the
contract.
● Any sales agreement, lease, or employment contract are common
examples of a bilateral contract.
 ● A unilateral agreement, in contrast, requires only one party to commit to
an obligation.

Several types of credit derivatives exist, including:

● Credit default swaps (CDS)

● Collateralized debt obligations (CDO)
● Total return swaps
● Credit spread options/forwards

In all cases, the price of a credit derivative is driven by the

creditworthiness of the party or parties involved. Often a credit
derivative will be triggered by a qualifying credit event, such as a
default, missed interest payment, credit downgrade, or bankruptcy.

● Creditworthiness is how a lender will tell if you will default on your debt
obligations.
● Creditworthiness is determined by several factors including your
repayment history and credit score.
● Improving or maintaining your creditworthiness is as simple as making
your payments on time.

● A credit event is a negative change in a borrower's capacity to meet its

payments, which triggers settlement of a credit default swap.
● The three most common credit events are 1) filing for bankruptcy, 2)
defaulting on payment, and 3) restructuring debt.

Understanding a Credit Derivative

As their name implies, derivatives stem from other financial instruments.
These products are securities whose price depends on the value of an
underlying asset, such as a stock's share price or a bond's coupon. In the
case of a credit derivative, the price derives from the credit risk of one or more
of the underlying assets.
A long put is a right (though not an obligation) to sell an asset at a set price,
known as the strike price, while a long call is a right (though not an obligation)
to buy the underlying asset at a set price. Investors use long puts and calls to
hedge or provide insurance against an asset moving in an adverse price
direction. The flip side of these types of trades is short puts and calls, whereby
the person entering into a short position has the obligation to purchase the
asset, in the case of the put, or sell the asset, in the case of a call.

In essence, all derivative products are insurance products, especially credit

derivatives. Derivatives are also used by speculators to bet on the direction of
the underlying assets.

The credit derivative, while being a security, is not a physical asset. Instead, it
is a contract. The contract allows for the transfer of credit risk related to an
underlying entity from one party to another without transferring the actual
underlying entity. For example, a bank concerned that a borrower may not be
able to repay a loan can protect itself by transferring the credit risk to another
party while keeping the loan on its books.

Example of a Credit Derivative

Banks and other lenders use credit derivatives to remove the risk of default
from a loan portfolio—in exchange for paying a fee, referred to as a premium.

Assume Company ABC borrows $10 million from a bank. Company ABC has
a bad credit history and must buy a credit derivative as a condition of the loan.
The credit derivative gives the bank the right to "put" the risk of default onto a
third party, thereby transferring the risk to this third party.

In other words, the third party promises to pay back the loan and any interest
should Company ABC default, in exchange for receiving an annual fee over
the life of the loan. If Company ABC does not default, the third party profits in
the form of the annual fee. Meanwhile, Company ABC receives the loan, and
the bank is covered in case of default. Everyone is happy.

Valuing Credit Derivatives

The value of a credit derivative is dependent on both the credit quality of the
borrower and the credit quality of the third party, referred to as the
counterparty.
 ● A counterparty is simply the other side of a trade—a buyer is the
counterparty to a seller.
● A counterparty can include deals between individuals, businesses,
governments, or any other organization.
● Counterparty risk is the risk that the other side of the trade will be
unable to fulfill their end of the transaction.
● In many financial transactions, the counterparty is unknown and the
counterparty risk is mitigated through the use of clearing firms.

In placing a value on the credit derivative, the credit quality of the counterparty
is more important than that of the borrower. In the event the counterparty goes
into default or in some way cannot honor the derivatives contract—pay off the
underlying loan—the lender is at a loss. They would not receive the return of
their principal and they are out the fees paid to the third party.

On the other hand, if the counterparty has a better credit rating than the
borrower, it increases the quality of the debt overall.

Credit Derivative Benchmark Indices

While credit derivatives usually trade OTC, there are now various credit
derivative indexes that traders can use as a benchmark to value the
performance of their holdings. Most of these indexes track and measure total
returns for the various segments of the bond issuer market focusing on CDS.

For instance, The credit default swap index (CDX), formerly the Dow Jones
CDX, is a benchmark financial instrument made up of CDS that have been
issued by North American or emerging market companies. The CDX was the
first CDS index, which was created in the early 2000s and was based on a
basket of single issuer CDSs.

The CDX is itself a tradable security: a credit market derivative. But the CDX
index also functions as a shell, or container, as it is made up of a collection of
other credit derivatives: credit default swaps (CDS).