Defining a Derivative
A financial contract whose value is based on an underlying asset or benchmark is referred to as a derivative. A derivative is an agreement between two or more participants that can transact over-the-counter (OTC) or on an exchange.
These contracts have their own risks and can be used to trade any number of assets. Derivatives prices are based on changes in the underlying asset. These financial instruments can be traded as a risk hedge and are frequently utilized to get access to specific markets. Derivatives can be used to take on risk in the hopes of receiving a similar reward (speculation) or to reduce risk (hedging). Risk (and its rewards) can be shifted from risk-averse people to risk-takers through the use of derivatives.
How Do Derivatives Work
A complicated kind of financial security that is established between two or more parties is called a derivative. There are many different types of derivatives, including those involving stocks, bonds, and economic indicators.
Derivatives allow traders to trade a variety of assets on particular markets. Derivatives are generally regarded as a type of sophisticated investing. Stocks, bonds, commodities, currencies, interest rates, and market indices are the most often used underlying assets for derivatives. Changes in the price of the primary instrument, or underlying asset, determine the contract values.
Derivatives can be used to lend leverage to holdings, speculate on the direction of an underlying asset’s movement, or hedge a position. These assets are bought through brokerages and are frequently swapped on exchanges or over the counter.
It’s critical to keep in mind that businesses that hedge are not making wagers on the commodity’s price. Rather, the hedge serves as a tool for risk management for each party. Every party incorporates their profit or margin into the price, and the hedge serves to prevent those earnings from being lost due to fluctuations in the commodity’s price.
Counterparty risk, or the likelihood that one of the parties to a transaction could default, is typically higher for OTC-traded derivatives. These contracts are unregulated and involve commerce between two private parties. The investor could buy a currency derivative to lock in a particular exchange rate in order to mitigate this risk.
Currency futures and currency swaps are two examples of derivatives that could be used to hedge this kind of risk.
Various Derivative Types
These days, derivatives have many more applications and are based on a wide range of transactions. Even derivatives based on meteorological data exist, such as those that indicate how much rain or how many sunny days a place receives.
Derivatives come in a wide variety that can be utilized for speculation, risk management, and position leveraging. Derivatives cater to almost every demand and risk tolerance, and the market is still expanding.
Derivative items fall into two categories: “lock” and “option.” Lock products, obligate the parties involved from the beginning to the terms specified for the duration of the contract. On the other hand, option products, such as stock options, give the holder the choice—but not the obligation—to purchase or sell the underlying securities at a given price on or before the option’s expiration date. Futures, forwards, swaps, and options are the most popular categories of derivatives.
Futures
An agreement between two parties for the purchase and delivery of an item at a certain price at a later period is known as a futures contract, or simply futures. Standardized contracts that are traded on an exchange are called futures. A futures contract is used by traders to speculate on the price of an underlying asset or to hedge their risk. Each of the parties has an obligation to carry out the agreement to purchase or sell the underlying asset.
Settlements of Futures in Cash
Not every futures contract has the underlying asset delivered to settle when it expires. It is improbable that either party in a futures contract would choose to arrange for the delivery of a sizable quantity of crude oil barrels if they are both speculative traders or investors. By closing (unwinding) their contract with an offsetting contract prior to its expiration, speculators can terminate their commitment to buy or deliver the underlying commodity.
Forwards
Like futures, forward contracts, often known as forwards, are not traded on an exchange. The only way to exchange these contracts is over-the-counter. The buyer and seller can alter the terms, amount, and settlement procedure when a forward contract is made.
One kind of credit risk is the possibility that the parties won’t be able to fulfill their end of the bargain. The other party may be left with no options and may lose the value of its position if one of the parties becomes bankrupt.
Swaps
Another popular kind of derivative is a swap, which is frequently used to swap one type of cash flow for another. An interest rate swap could be used, for instance, by a trader to move from a variable interest rate loan to a fixed interest rate loan or vice versa.
Let’s say that Company A takes out a $1,000,000 loan, with a variable interest rate that is currently set at 6%. While the company is exposed to this variable-rate risk, they might be worried about growing interest rates that would drive up the cost of this loan or run into a lender who is hesitant to give more credit.
Swaps can also be designed to hedge against risks related to currency exchange rates, loan defaults, and cash flows from other company ventures. Derivatives that deal with the cash flows and possible defaults of mortgage bonds are very common. Actually, in the past, they were a little too well-liked. These kinds of swaps carried counterparty risk, which ultimately contributed to the 2008 credit crisis.
Options
Similar to a futures contract, an options contract is an agreement between two parties to purchase or sell an asset at a specified price at a future date. Options and futures differ primarily in that an option buyer is not required to carry out their commitment to purchase or sell. Unlike futures, which are obligations, this is merely an opportunity. Options can be used to speculate or hedge against changes in the price of the underlying asset, just like futures.
Benefits and Risks of Derivatives
Benefits
Derivatives can be a helpful tool for both businesses and investors. Traders can frequently buy derivatives on margin, which entails using borrowed money to do so; they now cost even less as a result.
Risks
Because derivatives are based on the value of another asset, they are challenging to value. One of the risks associated with OTC derivatives is counterparty risk, which can be hard to estimate or foresee. Additionally, it is challenging to precisely match a derivative’s value with the underlying asset because of these variables.
The table below summarizes the pros and cons of derivatives trading:
| Pros (These benefits frequently come at a limited price) | Cons |
| Fix prices. | Variations in the time remaining till expiry. |
| Hedge against fluctuations in prices. | The underlying asset’s holding costs. |
| Reduce risk. | Rates of interest. |
| Can be leveraged. | Sensitive to elements of supply and demand. |
| Used to diversify a trader’s portfolio. | Subject to default by the counterparty (if it is OTC). |
The derivative is susceptible to both market fluctuation and risk since it lacks intrinsic value and derives all of its value from the underlying asset. Regardless of what happens to the price of the underlying asset, supply and demand dynamics have the potential to cause a derivative’s price and liquidity to fluctuate.
Lastly, since leverage works both ways, derivatives are typically leveraged instruments. It can raise the pace of return, but it also accelerates the accumulation of losses.
