Everything you need to know about derivatives

Derivatives are powerful tools used in today’s economy by traders and investors. But what are they, the types of derivatives, and how are they used? Let’s figure it out.

What is a derivative?

Any financial contract under which the parties obtain the right or obligation to perform some action about the underlying asset is called a derivative. It is typically agreed between two or more parties who can trade on an exchange or over-the-counter (OTC).

These contracts are used for trading all kinds of assets. Prices for derivatives are derived from price shifts in the underlying asset. They are commonly used to access specific markets and can be traded to hedge against risk.

Derivatives can be used to either mitigate risk (aka hedging) or assume risk with the hope of commensurate reward (speculation). Derivatives can shift risks (and the rewards) from the risk-averse to the risk seekers, who think they can benefit from the transaction in their own way.

Understanding derivatives

Derivatives are a complex kind of financial security set among two or more parties. They are usually used by advanced investors and are used to gain access to specific markets to trade different assets. Stocks, currencies, commodities, bonds, interest rates, and market indexes are some of the common underlying assets used for this purpose. All contract values thus depend on price changes of the underlying asset.

Traders use derivatives to hedge a position, forecast an underlying asset’s directional movement, or give leverage to their holdings. Many of these assets are purchased through brokerages and are traded routinely on exchanges or OTC. The Chicago Mercantile Exchange (CME) is one of the world’s largest exchanges dealing with derivatives.

When companies hedge, they are not investing because they think they will profit from changes in the commodity’s price. Instead, they hedge merely to manage their risk. Every party has its margin or profit included in the price, and the hedge is a strategic move to protect those profits from going to waste by market shifts in the commodity’s price.

Generally, there is a greater chance of counterparty risk in OTC-traded derivatives. Counterparty risk is the risk that one of the parties taking part in the transaction might default. Since these contracts trade between two private parties, they are unregulated, and each party has to take measures to reduce their risk as much as possible.

Investors can purchase a currency derivative to set a specific exchange rate to hedge this risk. Examples of derivatives that could be used to hedge such risk are currency swaps and currency futures.

Special considerations

Differing values of national currencies were an added complication to international trades, and derivatives were the system traders came up with to counter it. Therefore, derivatives were first used internationally in trading goods to ensure consistent exchange rates. To understand this better, let’s take an example of a European investor with investment accounts denominated in euros (EUR).

The investor completes a purchase of shares of a company based in the U.S. via a U.S. exchange using U.S. dollars (USD). Their acquisition of this stock leaves them exposed to currency exchange rate risks. The exchange rate risk is the chance that the euro’s value might increase about the USD. If this happens, when the investor sells their shares, their profits will be less valuable (than originally speculated) when converted into euros.

An investor speculating that the euro might appreciate versus the dollar would benefit by using a derivative that would rise in value simultaneously with the euro. While using derivatives to forecast the price changes of an underlying asset, there is no need for the investor to have a portfolio presence or holding in the underlying asset itself.

Types of derivatives

Today, derivatives have many more uses and are based on various transactions. There are derivatives based on weather data, such as the number of sunny days in the region or the amount of rain an area receives. Investors can use various derivatives to increase position, speculate and manage risk. The derivatives market constantly grows and offers products to suit any risk tolerance or need.

Derivative products can be divided into two broad categories:

1. Option products (such as stock options) give the holder the right (without obligation) to purchase or sell an underlying asset or security at a set price on or before an agreed expiration date.
2. Lock products (such as swaps, futures, or forwards) bind the parties to an agreed-upon contract and its terms.

The most frequently seen derivative types are futures, swaps, forwards, and options.

Futures

A futures or futures contract is an agreement between two parties to buy and deliver an asset at an agreed price on a set date in the future. These are standardized contracts that can be traded on an exchange. Investors can use a futures contract to speculate on the underlying asset’s price or hedge risks. It assumes that the parties are obliged to buy or sell the underlying asset.

For example, suppose Company A buys a futures contract on October 6, 2021, for oil at $62.22 per barrel. The futures contract expires on November 19, 2021. The company makes this purchase because it needs the oil in November but is concerned that the oil price will rise before it needs it. By buying an oil futures contract, the company hedges the risk of rising prices since the seller is now obliged to deliver oil for $62.22 per barrel at the contract’s expiration.

Even if oil prices rise to $80 per barrel by November 19, 2021, Company A will be able to receive the oil delivered by the seller at $62.22 per barrel. If they don’t need the oil, the company can sell the contract to a third party before it expires and keep any profit.

In this example, the futures buyer and seller can hedge their risk. Company A required oil in the future and had to offset the risk of any price rises by November by purchasing a position in a futures contract for oil. On the other hand, the seller might have been an oil company concerned about dropping oil prices and, therefore, eliminated that risk by selling a futures contract that locked the price it would receive for the oil in November.

Cash settlements of futures

Not every futures contract needs to be settled at expiration by delivery of the underlying asset. If both parties to a futures contract are speculators or investors, it is unlikely that either will have arrangements to supply or receive large barrels of crude oil. Therefore, offset contracts usually exist so traders can terminate their obligation to purchase or deliver a commodity by closing their contract before it expires.

Most derivatives are cash-settled. The profit or loss in the trade is just an accounting cash flow directed to the trader’s brokerage account. Many stock index futures, interest rate futures, and unusual instruments such as weather or volatility futures are futures contracts that are commonly cash-settled.

Forwards

Forwards or forward contracts are similar to futures. However, they are not traded on an exchange but on the over-the-counter market. When agreeing, the buyer and seller of a forward contract can set the size, terms, and settlement process. Forward contracts have a higher degree of counterparty risk for the parties because they are OTC products.

The counterparty risk is a credit risk in which the parties might not fulfill their obligations outlined in the agreed contract. If one party dissolves, the other party might have no recourse and lose the value of its position.

Swaps

Swaps are another common type of derivative. They are often used to exchange one kind of cash flow for another. For example, a trader may use an interest rate swap to move from a fixed-rate loan to a variable-interest-rate loan or vice versa.

As an example, let’s say that Company PQR borrows $2000 and agrees to pay a variable interest rate on the borrowed amount. The interest rate is currently 6%, but PQR might be concerned about increasing interest rates and increasing the costs of this loan. Alternatively, they might find a lender reluctant to provide more credit when the company has this variable-rate risk.

Assume PQR creates a swap with Company XYZ. XYZ is ready to swap the payments owed by PQR on the variable-rate loan for the payments owed by XYZ on a fixed-rate loan of 7%. The result of this swap would be that PQR will pay 7% to XYZ on its $2000 principal, and XYZ will pay PQR 6% interest on the same principal. To begin with, PQR will just pay XYZ the one-percentage-point difference between the two loan rates swapped.

In the future, if interest rates fall, let’s say that the rate on the original variable-rate loan is now 5%, company PQR will now have to pay Company XYZ the two-percentage-point difference. If interest rates rise to 9%, XYZ will have to pay PQR the difference of two percentage points between the two interest rates on loan. No matter how the interest rates change, Company PQR will have achieved its objective of turning its variable-rate loan into a fixed-rate loan.

Swaps can be used to exchange currency-exchange rate risks, loan default risks, and cash flows from other business activities. Cash flow and potential mortgage bond default-related swaps are also quite popular.

Advantages and disadvantages of derivatives

Consider the pros and cons of using derivatives for businesses and investors.

Advantages

Derivatives provide the opportunity to do the following:

• Mitigate risks.
• Hedge against unfavorable shifts in rates.
• Lock in prices.

Derivatives are also often purchased on margin. It means traders utilize borrowed funds to buy them, making them even less expensive.

Disadvantages

Derivatives are based on the price of other assets, which makes it difficult to decide their value. The major downside to OTC derivatives is counterparty risks, which can be challenging to predict or value. The value of derivatives is also sensitive to the following:

• Time left for expiration.
• Current interest rates.
• The cost of holding the underlying asset.

Derivatives are affected by the value of the underlying asset and other variables, so it is challenging to value a derivative with an underlying asset accurately.

Since the derivative has no value on its own (because its value is based on the underlying asset), it is sensitive to market risk and market sentiment. Supply and demand factors can alter a derivative’s price. Its liquidity can rise and fall, unrelated to what is happening with the value of the underlying asset.

Finally, it is important to remember that derivatives are usually leveraged instruments. Using leverage can cut both ways. It can increase the rate of return, but it can also make losses mount more quickly.

FAQs

A derivative is a complex financial tool, so it is essential to understand the intricacies of its use. Next, we will answer the most popular questions about derivatives.

What are derivatives?

A derivative is a security whose value is derived from an underlying asset. An example of a derivative would be an oil futures contract, whose value is dependent on the market value of oil.

What are some examples of derivatives?

Futures contracts, credit default swaps, and options contracts are all examples of derivatives. Apart from these, various derivative contracts are customized to meet the needs of a wide range of counterparties. Because derivatives can (and are) traded over-the-counter (OTC), they can be infinitely customized based on what the agreeing parties require.

What are the main benefits and risks of derivatives?

Derivatives can be an important tool for achieving financial goals. For example, a company that wishes to hedge against its investment in commodities can buy or sell energy derivatives such as oil futures. Similarly, investors can hedge their currency risk by purchasing currency forward contracts.

Investors can also employ derivatives to leverage their positions. This can be done by buying equities through stock options rather than shares. The main cons of derivatives are the inherent risks of leverage, counterparty risk, and the systemic risks that complicated webs of derivative contracts can cause.

Conclusion

Derivatives can be powerful financial tools when used correctly. However, they can be difficult to understand and utilize, which is why it is often said to be a tool used by advanced investors. It is essential to check the details and weigh the possible risks and rewards before using them.