What is a Derivative?
A derivative is a financial contract that derives its value from an underlying asset or benchmark. The most common types of derivatives are futures, forwards, options, and swaps.
These instruments can be used for speculation and hedging purposes. Derivatives allow parties to take on or transfer risk related to the underlying asset without the need to own the latter directly.
How Do Derivatives Work?
The value of a derivative contract is determined by the performance of the underlying asset. For example, an oil futures contract will rise and fall in value based on fluctuations in the price of oil.
The parties that issue and purchase a derivative contract agree to exchange cash flows at a future date based on the underlying asset’s price movements. The contract’s settlement can occur through the physical delivery of the asset or by settling the contract in cash.
Long and short positions in derivatives can generate profits or losses. A party who bets on the underlying increase in value takes a long position. One betting on a decrease takes a short position.
Futures contracts obligate both parties to fulfill the terms at expiration.
In contrast, options contracts give the holder the right but not the obligation to buy or sell the asset.
Swaps involve exchanging cash flows, like swapping fixed interest rate payments for variable rate payments.
Hedging and Speculation
The two primary practical uses of derivatives are hedging and speculation.
1. Hedging involves taking a derivative position to offset one party’s exposure to the underlying asset. This protects the portfolio against unfavorable price swings.
For example, a wheat farmer could sell wheat futures to lock in a certain price and protect their operations against falling wheat prices at harvest time. Meanwhile, an airline could hedge against rising fuel costs by buying oil futures.
2. Speculators aim to profit from price fluctuations of the underlying asset. They take on increased risks in hopes of generating attractive returns.
Hedgers transfer risk to speculators who are willing to accept it.
Common Underlying Assets
Derivatives can be constructed from almost any underlying asset, including the following:
- Equities: Single stocks or stock indices
- Interest rates: LIBOR, bond yields
- Foreign exchange: Currency pairs – i.e. EUR-USD
- Commodities: Agricultural, energy, metals
- Credit: Corporate and sovereign bonds
- Cryptocurrencies: Bitcoin, Ethereum
More exotic derivatives can be based on weather data, inflation rates, residential mortgages, and more. Almost anything that has a variable value can be used to write a derivatives contract.
Where are Derivatives Traded?
The over-the-counter (OTC) derivatives market involves private trades between two parties. They negotiate contract terms like size and settlement dates. OTC derivatives are not standardized and carry significant counterparty risk.
Exchange-traded derivatives (ETDs) are listed contracts sold on public exchanges. These standardized contracts have set expiration dates and terms. These formal exchanges act as intermediaries and guarantee performance, thus reducing counterparty risk.
Futures and options are commonly traded as ETDs. Swaps and forwards are commonly traded over the counter. OTC trading has been more strictly regulated since the 2008 financial crisis but continues to be to go-to method used by derivatives traders, as reflected by contract volume statistics.
Participants in the Derivatives Market
There are four major types of participants in the derivatives market:
Hedgers: Use derivatives to offset underlying asset risks related to their business. This includes commodity producers, corporations, and institutional investors.
Speculators: Take risky derivative positions to profit from asset price fluctuations. Speculators provide liquidity to the market.
Arbitrageurs: Identify and exploit mispriced derivatives to lock in risk-free profits through paired trades. These participants enforce pricing efficiency.
Market Makers: Stand ready to buy or sell contracts on exchanges to provide liquidity. They profit on bid-ask spreads.
Pros and Cons of Derivatives
Derivatives offer many benefits but also pose risks. Here’s a summary of the most relevant advantages and disadvantages of using and trading derivates.
Mitigate portfolio risks by taking offsetting derivative positions.
Traders can profit from correctly predicting price movements.
Small initial margins can be used to gain control over large contract values.
Active trading markets exist for standardized contracts.
OTC contracts can be crafted to cater to specific market needs.
Options contracts carry limited downside risks.
Valuing derivatives can be much more challenging compared to traditional securities.
Trading derivatives via the OTC markets can be risky if the counterparties are susceptible to defaulting on their commitments.
Some strategies involving significant leverage can result in large losses for operators.
Options sellers (writers) generate limited gains from their exposure.
The risks associated with derivatives, such as excessive leverage and counterparty defaults, were evident during the 2008 financial crisis. However, when used properly, derivatives remain an effective tool for risk management.
Types of Derivatives
When it comes to derivatives, there’s a range of options to consider. Below we’ll highlight four major types.
Futures contracts specify an agreement to buy or sell an asset at a future date for a predetermined price. Both parties are obligated to fulfill the contract at expiration. Futures trade on exchanges with standardized contract terms.
Futures are commonly used to hedge commodity prices, interest rates, and currency values. They can also be used by speculators to bet on asset price movements.
Futures utilize leverage and require investors to post margins. At settlement, contracts can be settled in cash or physically delivered of the asset.
Forwards are similar to futures but trade on the OTC market. This makes their terms more easily customizable.
Settlement occurs at expiration and involves exchanging the underlying asset for cash between counterparties.
Options give the holder the right but not the obligation to buy or sell the underlying asset on the expiration date at a preset strike price.
Call options confer the right to buy the asset, while puts confer the right to sell it. Options trade both over the counter and on exchanges.
Buyers pay a premium upfront and can exercise profitable options at expiration. Sellers collect the premium for taking on the obligation to buy or sell the asset if assigned. Options help hedge downside risks while providing some upside potential.
Swaps involve two parties exchanging a series of cash flows, like swapping fixed interest rate payments for variable rate payments.
Common swaps include:
- Interest rate swaps
- Currency swaps
- Credit default swaps.
Swaps are traded over the counter and typically carry counterparty risk. However, some can be centrally cleared.
Derivatives are versatile financial instruments that can be tailored to meet specific risk management, speculation, and portfolio management needs.
By providing exposure synthetically, derivatives unlock unique payoff structures and opportunities.
However, their performance is linked to underlying asset values, and this introduces some sophisticated risks that investors must understand before transacting with them.