Derivatives are financial instruments whose value is derived from an underlying asset – a stock, bond, commodity, currency, interest rate, or index. They are fundamental to how modern financial markets work, and understanding them is essential for any S&T interview and increasingly relevant for IB roles covering capital markets and structured finance.
Why Do Derivatives Exist?
Derivatives serve three core functions:
Hedging: Reducing risk exposure. An airline buys oil futures to lock in fuel costs. A UK company with US revenue buys USD/GBP forwards to protect against currency movements. A bank uses interest rate swaps to manage the mismatch between its fixed-rate lending and floating-rate deposits.
Speculation: Taking a directional view on an asset's price. If you believe oil prices will rise but don't want to physically buy barrels of oil, you buy oil futures. Derivatives allow you to take large positions with relatively small capital outlay (leverage).
Arbitrage: Exploiting pricing inefficiencies between related instruments. If an option is mispriced relative to its theoretical value, a trader can construct a riskless position to capture the difference.
The Four Main Types of Derivatives
Forwards
A forward contract is an agreement between two parties to buy or sell an asset at a specified price on a specified future date. Forwards are customised (any quantity, any settlement date) and trade over-the-counter (OTC) – meaning directly between two parties, not on an exchange.
Example: a UK company expects to receive $10m from a US client in 6 months. It enters a forward contract with a bank to sell $10m at a fixed GBP/USD rate. Regardless of where the exchange rate moves, the company knows exactly how many pounds it will receive.
Key risk: Counterparty risk. If the bank defaults, the company is exposed.
Futures
Futures are standardised forward contracts that trade on exchanges (like the Chicago Mercantile Exchange or ICE). Because they're exchange-traded, they use a clearinghouse as intermediary, eliminating counterparty risk.
Futures are marked to market daily – profits and losses are settled each day through margin accounts. This is different from forwards, where settlement only occurs at expiration.
'What's the difference between a forward and a future?' Forwards: OTC, customised, settled at maturity, counterparty risk. Futures: exchange-traded, standardised, daily mark-to-market, no counterparty risk (clearinghouse intermediary). Know this distinction – it's one of the most commonly tested basic derivatives questions.
Options
An option gives the holder the right, but not the obligation, to buy or sell an asset at a specified price (the strike price) on or before a specified date (the expiration date).
Call Option: Right to buy at the strike price. You buy a call if you think the underlying asset will rise.
Put Option: Right to sell at the strike price. You buy a put if you think the underlying asset will fall.
The buyer pays a premium for this right. The seller (writer) of the option receives the premium but takes on the obligation to fulfill the contract if exercised.
Key concepts:
In the money (ITM): A call is ITM when the underlying price exceeds the strike price. A put is ITM when the underlying price is below the strike price.
Out of the money (OTM): The opposite.
At the money (ATM): The underlying price equals (or is very close to) the strike price.
Intrinsic value: The amount an option is in the money. For a call: max(0, Stock Price − Strike Price).
Time value: The portion of the option premium above intrinsic value. Reflects the probability that the option will become more valuable before expiration.
Swaps
A swap is an agreement between two parties to exchange cash flows over a period of time. The most common type is an interest rate swap:
Interest Rate Swap: Party A pays a fixed interest rate; Party B pays a floating rate (typically SOFR or SONIA). The principal isn't exchanged – only the net interest payments. Used extensively by companies and banks to manage interest rate risk.
Example: a company has a £100m floating-rate loan. Interest costs rise when rates increase. To hedge, the company enters a swap paying fixed and receiving floating. The floating payments from the swap offset the floating payments on the loan, effectively converting its floating-rate debt into fixed-rate.
Currency Swap: Exchange of principal and interest payments in different currencies. Used for cross-border financing.
Credit Default Swap (CDS): An insurance-like contract where one party pays regular premiums in exchange for protection against a credit event (default) on a reference entity. CDS spreads are a key market indicator of perceived credit risk.
'Explain how an interest rate swap works in one sentence.' Party A pays fixed, Party B pays floating, on the same notional amount – only the net difference is exchanged. If you can explain this clearly and quickly, you've demonstrated you understand the mechanics.
Greeks (Options)
For anyone targeting S&T or options-related roles, the Greeks are essential:
Delta: How much the option price changes for a £1 change in the underlying. A call with delta 0.5 moves £0.50 for every £1 the stock moves.
Gamma: The rate of change of delta. High gamma means delta is changing rapidly – the option's sensitivity to the underlying is itself sensitive.
Theta: Time decay. How much the option price declines each day as expiration approaches. All else equal, options lose value over time.
Vega: Sensitivity to changes in implied volatility. Higher implied vol = higher option price.
Common Interview Questions
'How would you hedge a portfolio of UK equities against a market decline?' Buy put options on the FTSE 100 index, or sell FTSE 100 futures. The put provides downside protection while preserving upside (at the cost of the premium). Futures lock in the price but eliminate upside potential too.
'What happens to a call option's value when interest rates rise?' Call values increase slightly (higher rates increase the present value advantage of deferring the purchase). Put values decrease. This is a second-order effect and smaller than delta or vega impacts.
'If implied volatility increases, what happens to option prices?' Both calls and puts become more expensive. Higher volatility means a wider range of potential outcomes, which increases the value of the optionality.
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