Derivatives Fundamentals and Product Types
The building blocks
Forwards, futures, options and swaps all derive value from an underlying. Futures are standardised, exchange-traded and cleared, with symmetric obligations: both parties can gain or lose. Forwards are private contracts with counterparty risk. Options give the buyer a right, not an obligation, for a premium; the seller has an obligation. Swaps exchange cash flows and are mostly OTC.
NZX product set
NZX lists cash-settled derivatives including 90-day bank bill futures, 3-year and 10-year government stock futures, NZX 50 index futures and dairy futures such as whole milk powder and skim milk powder. Bank bill and bond futures are quoted on an index basis (100 minus yield), so the quotation moves inversely to yield. Dairy futures are priced in US dollars and settle against reference prices, giving processors and exporters a hedge for physical exposure.
Payoffs
A long futures position gains when the futures price rises; a short gains when it falls. A long call gains above strike plus premium; a long put gains below strike less premium; the maximum loss for a bought option is the premium. The exam tests whether you can separate obligation from right and identify the premium payer.
Worked example
A dairy processor expects 500 tonnes of whole milk powder. Assuming 25 tonnes per contract, it sells 20 futures contracts. If the price falls from US$3,200 to US$3,000 per tonne, the futures gain is US$200 × 25 × 20 = US$100,000, offsetting the lower physical sale value. The reasoning is that a short hedge profits when the underlying falls, protecting the seller.
Traps
Confusing options with futures; forgetting the premium; assuming futures always reduce risk; and ignoring basis risk between the contract and the physical product.