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What is a Derivative?



Efraim Landa is president of Effi Enterprises which assists entrepreneurs and emerging companies create value. The company offers growing companies hands-on executive management and leadership and helps them discover various ways of securing finances. They offer options such as introducing businesses to angel money, marketing strategies and divestures among many other options. Effi Enterprises works with emerging companies to help find the best solution for their particular situation. This may include stock options for employees, future contracts or any number of other strategies. Future contracts, options, and warrants are all common derivatives.

What is a derivative?

A derivative’s value is based on a contract between parties who are agreeing on an underlying financial asset, security or index. Some of the most common underlying instruments are bonds, currencies, market indexes, stocks interest rates and commodities. Some common derivatives are warrants, swaps, options, forward contracts and futures contracts. Basically, a derivative is an instrument which derives its price from another variable or financial asset. A stock option derives its value from that of a stock; and a swap gets its value from the interest rate index. A derivative obtains its value form an underlying asset and the derivative’s price will rise or fall along with the underlying asset’s value. The derivative’s value is based off of the price of the instrument and the payoff will mirror that of the instrument that they are based on.

A derivative is a contract on an underlying asset. There are many different derivatives but options are the most common type. When an owner purchases an options contract they have the right to purchase or sell the asset at a certain price prior to a pre-set date. The most common underlying assets for which contracts are purchase are stocks, commodities, bonds, currencies, market indexes and interest rates.

Basically, a derivative is a contract between a buyer and a seller. Unlike traditional investments, there is a pre-set expiration date. This time is established at the time the contract is purchased. Payoff is typically determined at the expiry most of the time. Occasionally there is no exchange of money when the contract is made.

Some very well established exchanges trade derivatives. The New York stock Exchange, the Chicago Board of Trade and the French CAC are three. Trades such as these are called exchange-traded derivatives which mean that the terms and features are highly standardized. The advantage to these is that they are regulated which is just an extra safeguard for investors.

Other types of derivative instruments like swaps, forwards and other exotic derivatives are traded over-the-counter. These have very flexible terms and a large number of underlying assets and combinations which can be purchased. These types of financial dealers can customize the derivatives for specific clients and their needs.

Why Derivatives?

The largest thing that makes derivatives appealing to businesses is that they allow a certain amount of leverage. This is a financial term which refers to the increase that occurs when a small quantity of money is all that is used to control another item which is of a larger value. An example is a mortgage. A person can gain control of a highly priced piece of property for a smaller amount of money. Derivatives can give this same type of leverage, or multiplication as a mortgage can. An investor can actually control company stock which has a large value by using a small amount of money. An investor has the opportunity to make more money than the company who is reaping the benefit of the investment.

However, if derivatives take a turn for the worse they can be very costly for a business. In 1995, trader Nick Leeson traded derivatives but the trades were not profitable and because of the leverage the losses were so huge for the Barings Bank of England that they ended up in bankruptcy. Warren Buffet, who is a very successful investor, is against using derivatives and he sees them in a very negative light. However, just like any investment there are always risks involved. Derivatives are a form of investing which have been part of business finance for many years and will likely remain an integral part for many years to come.

What are Stock Options?

Stock Options

Stock Options

Effi Enterprises is a business which offers financial consulting to various types of businesses. Mr. Efraim Landa began as an entrepreneur and offers his expertise on how to secure financial revenue for emerging businesses. There are many options available and Effi Enterprises can help businesses sort through the plethora of options to find the most profitable and practical solution for an emerging business’ needs. One of the benefits top companies are offering top paid executives are stock options. The question is why are they being offered and are they profitable for the employee and the business?

Definition of Stock Options

Employee stock options (ESO) are a type of reward in the form of equity in the company. Each company has different policies but most large scale companies offer equity compensation to their executives, and sometimes other employees as well. The employer gives the employee the option to purchase stock in the company by some very defined terms. Employers allow employees to purchase a specified number of company shares or stocks at a preset time and price. These are both specified by the employer. There can be several reasons why private and publicly held companies offer these options to their employees.

One reason is that the company wants to both attract and retain quality workers. They also want to allow employees to feel like they are partners or part owners of the business. Many companies offer stock options to employees to give them additional compensation above their salaries. Start-up companies such as those Effi Enterprises oversees are likely to make this available to employees as it allows them to hold on to more of their capital.

Benefits of Stock Options

When a company offers stock options to their employees the strike price is generally discounted and is close to the present market price. Options usually cannot be exercised for some amount of time so the hope is that the share’s price will increase so that later they can be sold for a profit. Offering stocks in the business can be beneficial for an employee as long as the business does well and stays in business. This is a way of allowing workers to invest in the business while reaping the benefit down the road. This is usually a nice incentive to help motivate workers to keep working and to perform satisfactorily. The financial condition of the business can have a direct influence on their investment.

When an employee purchases options they can convert them to stocks and then wait until the contract on the option expires and sell it off at a profit. They may also sell some of the stocks off for a profit when the contract is up; and save the rest of them for a later date. Lastly, the employee can choose to change all of the options for stock in the company in hopes that the price will continue to increase and they will realize a profit.

No matter which of the choices the employee decides on these options will have to be converted to stocks. The company usually offers a set amount of options and the employee can buy the amount that they want. Usually, the company will spread the vesting period out over 3, 5 or 10 years. Then they will allow employees to purchase a certain number of shares according to a set schedule. For instance perhaps a company offers options on 100 shares of stock in the company. The vesting schedule may be spread out over 4 years. The company may offer one-fourth of the options vested each of the next four years. For the employee that means that each year they can purchase 25 shares at the discounted price and then each year sell it at the current market price, or keep it. The hope is that the price will increase each year.

There is always an expiration date on options. This means that they can be exercised starting on a specified date and ending on a specified date. If they are not exercised according to the dates they are lost. And if the employee chooses to leave the company they only have the option of exercising their vested options and any future vesting is lost.

A company establishes a market or strike price on each of its shares of stock. They fix a price that is close to the share’s internal value and it is set by the board of directors by voting. These are not a risk free option because if the company loses the stock options will decrease in value as well. However, they can be beneficial to the employee and the employer alike.