• Definition:

Financial derivatives are contracts which are written on an asset (referred to as an “underlying asset”). The price of the contract depends on the price of the underlying asset.

• Main Types of Derivative:

1. Future Derivative

A binding agreement made in standardised size and form to make or take delivery of a specified quantity of a specified asset at a time in the future at a price agreed today.

2. Forward Derivative

A bespoke binding agreement made over the counter to make or take delivery of a specified quantity of a specified asset at a time in the future at a price agreed today.

Example:

Assume that the underlying asset is jet fuel. The price which AirAsia would like to fix is the price of jet fuel in June because it anticipates price rises in June. So, AirAsia will instruct a lawyer to write a derivative contract which fixes this price today for a transaction to take place in June. After signing the contract, AirAsia must buy the jet fuel at the price fixed, regardless of what is the market price of jet fuel in June.

• Outcome 1: AirAsia will make a gain if the fuel price in June skyrockets (ie: rises), as it will pay a lesser price using the lower rate set today.
• Outcome 2: AirAsia will make a loss if the fuel price in June is lower than today, but AirAsia will have no option but to pay the price fixed in the derivative contract today.

3. Option Derivative

An option derivative gives the party a right, but not an obligation, to buy or to sell a specified quantity of a specified asset at or before a specified date at a specified price.

Example:

You expect to receive RM10,000 in three months’ time. You want to convert the money to US dollars then, but would like to be certain about the amount you will get today. In other words, you would like to lock into an exchange rate today, which stands at $3.9/RM. However, you would not like to have the obligation to trade in three months’ time, but just the right to do so. So, you can take an option derivative from a bank by paying the bank a premium.

• Outcome 1: In July, the exchange rate is $3.4/RM (lower than what you fixed). You will then be delighted that you have bought your option in April and you will then use your right to sell your ringgit at $3.9/RM. (ie: using the exchange rate fixed 3 months ago). Note that the bank is obliged to trade with you because you have the derivative option.
• Outcome 2: In July, the exchange rate is $4.2/RM (higher than what you fixed). Since you had previously entered into an option derivative, so you can choose whether or not to trade at $3.9/RM (ie: the exchange rate fixed 3 months ago). Obviously, you will not trade using the option because you the current market exchange rate is better. So, if you choose not to exercise your option, the contract would then expire. The bank would not make any losses and simply pocket the premium you paid three months ago.