What are derivatives?

Definition of a derivative

Derivatives are a type of financial contract whose value is tied to the price of an underlying asset. The underlying asset could be a stock, bond, commodity, currency, or market index. Instead of owning the asset itself, traders use derivatives to speculate on price movements, hedge against risk, or gain market exposure with leverage.

The value of a derivative fluctuates based on changes in the underlying asset’s price. If an investor can correctly predict how an asset’s price will move, they can profit from the derivative.

Derivatives can either be traded on major exchanges, like the Chicago Mercantile Exchange (CME), or over-the-counter (OTC) through private agreements between buyers and sellers. They’re generally considered an advanced form of investing.

Types of derivatives

There are four main types of derivatives: options, futures, forwards, and swaps.

Options

Options give investors the right, but not the obligation, to buy (call option) or sell (put option) an asset at a set price within a specific period of time.

For example, consider Stock XYZ currently trading at $25. If an investor believes that stock will go up in price, they can buy a call option with a strike price of $25, meaning they have the right (but not the obligation) to buy the stock at that price before the option expires.

If Stock XYZ increases to $28, the investor can exercise the option, buying the stock at $25 and immediately selling it at $28, making a $3 profit per share (minus the option’s premium). If Stock XYZ falls to $23, the investor can let the option expire and only lose the premium.

Options provide flexibility, but they come with a premium (the cost of the option) and the risk of expiration. If an option isn’t used before its expiry date, it becomes worthless and the investor loses the premium.

Futures

Futures contracts are similar to options, only they legally require the buyer to purchase (or the seller to deliver) the underlying asset at a predetermined price on a future date. They are similar to options, only there’s no option – it’s an obligation.

Futures contracts are traded on major exchanges and often used for hedging risks. For example, farmers might sell futures contracts for their crops to lock in prices ahead of harvest. Investors use futures contracts for speculation, aiming to profit from price fluctuations in assets like gold or oil.

Unlike options, which are customised, futures contracts are standardised and highly liquid.

Forwards

Forwards work like futures, except they’re not traded on exchanges. Instead, they are private agreements traded OTC between two parties. This means they can be customised based on specific needs, making them useful for businesses hedging against commodity price swings or currency fluctuations.

Unlike futures, however, forwards lack regulation. This can make them riskier as there’s no guarantee that the other party will fulfil their obligation. Futures also aren’t standardised, which makes them less liquid and harder to exit compared to futures.

Swaps

Swaps are contracts where two parties exchange financial obligations, usually cash flows based on interest rates, currencies, or credit risks. The most common type is an interest rate swap, where two parties agree to exchange a fixed interest rate for a floating rate to manage interest rate exposure.

Other types of swaps include currency swaps, where investors exchange payments in different currencies, or credit default swaps, which are a form of protection against bond defaults. Swaps are not traded on exchanges – they are custom agreements between institutions.

Roles of derivatives

Derivatives can serve multiple purposes in investment, whether it’s hedging against risk, speculating on price movements, or taking advantage of arbitrage opportunities.

Hedging

One of the main functions of derivatives is hedging, or protecting against unfavorable price movements. Hedgers use derivatives to lock in today’s prices for assets or commodities they will buy or sell in the future, helping reduce price uncertainty.

For example, a farmer who expects to sell wheat in six months’ time might sell wheat futures today. If market prices drop, the farmer is protected as they’ve already secured a price through the futures contract. In another example, a company that issues bonds might use interest rate swaps to convert variable-rate debt into fixed-rate debt, helping make future payments more predictable.

Speculation

Speculators use derivatives to profit from price fluctuations without directly owning the underlying asset. Because derivatives require less upfront capital and are highly liquid, they can be an efficient way to bet on price movements.

For example, a trader who believes the S&P 500 will rise might buy call options on the index instead of purchasing all the individual stocks in the basket. If the index moves in their favour, they can sell the options for a profit – all without ever owning the actual stocks themselves.

Speculation can be extremely risky. Although potential gains can be significant, losses can be just as steep. Before doing any speculative trading with derivatives, traders should have a solid understanding of the market and a strong risk management strategy in place.

Arbitrage

Arbitrage involves taking advantage of temporary price discrepancies in derivatives to earn a profit. For example, if gold futures are trading significantly higher than the spot price of gold, an arbitrageur could buy gold at the lower spot price, sell gold futures at the higher price, and deliver the gold into the futures contract at expiration, locking in a profit.

Benefits and risks of derivatives

Benefits of derivatives

Some of the advantages of trading derivatives include:

• Risk management: Derivatives can be an effective risk management tool, allowing businesses and investors to lock in price and protect against unfavorable market movements.
• Price discovery & liquidity: Derivatives attract a range of market participants, helping increase trading activity, narrow bid-ask spreads, and improve market liquidity.
• Lower capital requirements: Derivatives provide exposure to stocks, commodities, or currencies without needing to purchase the assets outright. This allows investors to control a larger position with less capital.
• Profit opportunities in any market: Some derivatives, like options contracts, allow traders to profit in both rising and falling markets depending on their position.

Risks of derivatives

Despite their benefits, derivatives also come with certain risks. These include:

• Leverage can magnify losses: While trading on margin can increase profits, it can also amplify losses. Even small market movements in the wrong direction can wipe out a trader’s position.
• Complexity: Derivatives can be complex and difficult to value because their prices can depend on multiple factors, like interest rates or time to expiration.
• Counterparty risk: OTC derivatives, which are privately negotiated rather than being exchange-traded, carry a risk that the other party may default. Such a situation could lead to significant financial losses.
• Liquidity issues: Some derivatives – especially those that are customised – may be hard to buy or sell, meaning traders could get stuck in a position they can’t exit easily.

The mechanics and valuation of derivatives

Mechanics of derivatives

The key elements of a derivatives contract include:

• Underlying asset: The asset from which the derivative contract ‘derives’ its value (e.g. a stock, commodity, or currency)
• Contract type: Whether options, futures, forwards, or swaps
• Expiration date: The date when the contract must be settled or exercised
• Strike price (for options): The agreed-upon price at which the option can be exercised.

Valuation of derivatives

Derivatives are often valued based on the market price of the underlying asset, but their pricing also depends on other factors like time to expiration, volatility, or interest rates. One of the main principles behind derivatives valuation is arbitrage-free pricing. This ensures that a derivative’s price remains aligned with its underlying asset’s market value, helping prevent arbitrage opportunities.

Other methods can be used to value derivatives, depending on the type:

• The Black-Scholes model can be used to calculate options pricing based on the current price of the underlying asset, the option’s strike price, time to expiration, market volatility, and risk-free interest rates.
• Futures and forwards can be valued using the cost of carry model, which is based on the spot price of the underlying asset plus any costs associated with holding it (e.g. storage or financing).
• Discounted cash flow analysis is often used to price swaps by calculating the present value of future cash flows from the swap agreement.

Exploring the derivatives market

Exchange-traded derivatives (ETDs)

Exchange-traded derivatives are standardised options and futures contracts traded on regulated exchanges like the CME and Intercontinental Exchange (ICE). These contracts come with predefined terms (i.e. expiration dates, contract sizes, and settlement procedures).

Exchange-traded derivatives are well-regulated, highly liquid, transparent, and carry low counterparty risk. However, they also lack customisation and flexibility, which can make them less effective for unique risk management strategies.

Over-the-counter (OTC) derivatives

OTC derivatives are private contracts negotiated directly between parties without using an exchange. These contracts, like forwards and swaps, are highly customizable. This means terms like contract size, expiration, and settlement are all negotiable, allowing businesses and institutions to create contracts that fit their specific risk management needs.

Because OTC contracts aren’t traded on exchanges, they lack transparency and come with a higher counterparty risk. They are also less liquid than exchange-traded derivatives.

The role of derivatives in risk management

Derivatives and risk management

Derivatives play an important role in risk management, where they’re used to hedge against price fluctuations in stocks, commodities, currencies, or interest rates. Investors and businesses use derivatives to lock in prices, helping reduce uncertainty and protect against adverse market movements.

For example, a company that relies on crude oil can use futures contracts to lock in a fixed price for oil purchases, helping protect from rising oil prices. Essentially, derivatives provide a way to stabilise returns and reduce exposure to market volatility.