What Is a Derivative?

What is a derivative?

Derivatives are complex financial contracts that describe the terms under which the underlying asset could be bought or sold. Some derivatives obligate a user to buy or sell the underlying asset, under certain terms, on or before a specific expiration date. Other derivatives give the buyer the right — but not an obligation — to buy or sell the underlying asset.

Commodities, stocks, bonds, interest rates and market indices make up the most common underlying assets for derivatives.

Derivatives may be traded over the counter (OTC), typically through a broker-dealer network, or on exchanges like the Chicago Mercantile Exchange (one of the world's largest derivatives exchanges). A key difference between the two is that exchange-traded derivatives are regulated and standardized, while OTC derivatives are not.

While you may profit more from an OTC derivative, you'll also face more counterparty risk (the chance that one party will default on the contract).

The cost of a derivative is determined by fluctuations in the price of the underlying asset, which means they have the potential to be volatile. Investors typically purchase derivatives to hedge risk or to assume risk through speculation .

• An investor who uses a derivative to hedge a position locks in a price to buy or sell the underlying assets in order to protect against losses from price changes in the future.
• An investor who speculates buys the derivative at a much lower investment cost than holding the actual underlying asset. He hopes to use the leverage of the derivative to participate in the gains if the underlying asset increases in price.

Types of derivatives

There are several types of derivatives, but most individual investors will likely only deal with futures and options (such as commodity futures and stock options). Forwards and swaps are more likely to be used by companies seeking ways to mitigate business risks or raise funds.

Futures

A futures contract is an agreement between two parties to buy or sell an asset at a future date. These contracts are typically designed to offset the risk of losses from volatile asset prices. The contract designates terms for the delivery or cash settlement of a specific asset and requires the contract holder to settle the contract by a specific deadline, called the expiration date. The underlying assets for futures are often commodities, such as agricultural products, but can include stocks.

Futures are particularly useful in business to help companies guarantee a certain level of income by locking in prices for products they'll sell in the future or securing supplies at a specific price. However, they can also be used by individual investors to speculate on the rise or fall of asset prices.

For example, a farmer grows a corn crop in early spring with expectations of selling a specific number of bushels of corn in late fall. By entering a futures contract to sell the corn at a set price on a specific date, the farmer locks in the price he will be paid for the specific amount of corn. This allows the farmer to lock in an exact profit and to protect against an unexpected price drop The party on the other side of the contract, known as the counterparty, is then obligated to pay the farmer the agreed-upon price at the specific date, even if the price has fallen. If, for instance, the price of corn today is $6 a bushel, the farmer can buy a future guaranteeing a price of $7 a bushel. Then if the price falls below $6, the farmer will still get paid $7 a bushel.

In the same vein, companies may invest in futures to secure supplies at a reasonable price. A company that depends on oil may purchase a futures contract agreeing to purchase a certain amount of oil at a set price. If oil prices rise before the derivative's expiration date, the company avoids paying the higher price..

Speculators who don’t want the underlying assets can purchase futures to bet on the direction that the asset’s price will move before the contract expires. In this case, the speculator needs to get rid of the contract before the expiration date or else they will be obligated to buy and take delivery of the underlying asset.

Futures are traded on an exchange, which sets the standards for each contract. Since the contracts are standardized, the cost of futures depends on the standard amount of the underlying asset. For example, oil is measured in barrels of about 42 gallons and each futures contract for oil is 100 barrels.

Futures are locked derivatives, which means that the contract holder must settle the contract by the expiration date. However, these contracts can also be sold at any time before the expiration date (as in the case of the speculator above).

Forwards

Forward contracts are similar to futures contracts in that they describe an agreement between two parties to buy or sell an asset at a future date. The big difference is that forward contracts can be easily customized to a buyer's needs.

Forwards are not traded on an exchange; they are OTC products defined by the parties participating in the transaction.
As OTC products, they also carry a greater degree of counterparty risk. Counterparty risk is the risk that the counterparty fails to fulfill the agreement, by going into default, for instance.The goal of forwards is to hedge against volatility as a means of managing costs and projecting future revenues, which makes them particularly useful in business.

Since they are not purchased on an exchange, no money is involved when a forward contract is agreed upon. When a forward contract expires, it's either settled by physical delivery of the underlying asset described or through a cash settlement. When physical delivery of an asset is particularly difficult, a cash settlement can be used to allow both parties to reach a satisfactory solution. For example, when an asset price doesn't climb to the expected rate, the buyer can pay the seller a settlement to make up for the difference in cost.

When a forward contract is settled, the seller can sell the product on the open market at the current rate to recoup the remainder of the cost without the need for a complex delivery. In turn, the buyer would purchase the necessary product on the local market for simplified delivery on an as-needed basis.

Since forwards aren't standardized contracts, they don't maintain the same liquidity as futures to attract individual investors.They also require participants to take on higher third-party risk because parties may not live up to the obligations outlined in the contract. To help mitigate this risk, parties involved in a forward contract can offset their risk by including additional counterparties to the contract. However, the counterparty risk increases with each new addition.

Swaps

Swaps, another OTC derivative, are typically used to exchange one kind of cash flow with another. Swaps are customized contracts that are traded over the counter between two private parties. Firms and financial institutions dominate the swaps market. The most common use of swaps is to hedge interest rates on a loan or currency exchange rates.

An interest rate swap allows a company to enter into a contract that lets them pay a fixed interest rate instead of a variable rate. For example, Company A borrows a significant amount of money for a business investment and pays a variable rate on the loan, which is currently 6%. Instead of taking on the risk of rising interest rates during the life of the loan, the company creates a swap with Company B. The swap states that Company B will exchange (swap) the payments on the variable rate loan for payments on a fixed loan with a higher interest rate.

Upon entering the swap, Company A pays Company B the interest percentage difference. Then, Company B takes responsibility for Company A's original loan with a variable rate, while Company A pays off a fixed-rate loan. If rates increase, Company A has avoided the rate hike. However, if rates decrease, Company B makes the additional profit realized with lower interest rates for the term of the loan.

Swaps can also be constructed to mitigate currency exchange rate risk. In this type of swap, counterparties exchange the principal amount and interest rates denominated in different currencies, hedging against currency exchange rate fluctuations.
Swaps are generally used to help companies mitigate currency fluctuation rates. As a result, they generally only involve financial institutions and companies rather than individual investors.

Options

An options contract is similar to a futures contract in that it's an agreement between two parties to buy or sell an asset at a specific price by a certain expiration date. The biggest difference between options and futures is that the buyer is not obligated to exercise the option. Traders and investors buy and sell options for several reasons. They can be used by investors to hedge the risk exposure of their portfolios or by traders to invest in the potential gains of an asset at a lower cost than buying shares of the asset.

Options can be either American or European. American options allow a user to enact them at any time after purchasing through their expiration date or let them go unused. European options can only be enforced on the expiration date, or they go unused. Like futures, options can trade on exchanges (where they are regulated) or OTC (which allows for more customization but also increases risk).

Options come in two basic forms.

• Calls: Call options give the holder the right, but not the obligation, to buy the underlying security at an agreed-upon price on or before the expiration date. This is basically a bet that the price will go up, so the option to buy the asset at a lower price helps the investor lock in a profit..
• Puts: Put options give the holder the right, but not the obligation, to sell the underlying stock at an agreed-upon price on or before the expiration date. A put is a bet that the price will go down. With the ability to sell the option at a higher rate, the investor can either lock in a profit or hedge against a loss.

With both calls and puts, investors have the option not to use this type of derivative at all. When the asset doesn't perform as expected, the user simply lets the option expire and the only loss is the cost of the derivative.

What are the risks of derivatives?

Derivatives are generally significantly less expensive than investing in stocks and can be used to help investors hedge risks associated with assets in their portfolio. Yet, even without a large investment, derivatives have risks. As one of the more complex investment types, derivatives can get complicated and result in considerable losses.

• A derivative is dependent on the underlying asset. Since the derivative has no value of its own, supply and demand factors can cause a derivative's price to rise and fall, regardless of what happens with the underlying asset. As a result, derivatives are notoriously hard to value.
• The time restriction can disrupt investment potential. When an investor purchases stocks, they can buy or sell based on current market conditions. A derivative must be used before or on the expiration date, which could be the day before the underlying stock soars in value.
• OTC derivatives come with significant counterparty risk. Without regulations, the derivative is only as reliable as the individuals or companies using it.
• Leverage can be a double-edged sword. When investors invest in derivatives to speculate, they use minimal investments to gain exposure to large gains. However, the leverage can turn against an investor. The smaller investment means losses add up quicker. While a small loss would have little impact on a shareholder, an investor holding a derivative can be completely wiped out.

Why investors use financial derivatives

While financial derivatives have risks, they aren't without rewards. Investors use them in conjunction with other investments in their portfolio or as a gateway to investing in assets they wouldn't otherwise have access to. When used to hedge risk, investors can purchase derivatives that allow them to sell an asset that is declining in value at a more favorable price.
If the asset doesn't decline as expected, the derivative can be sold for a profit or go unused if it's an option. As a result, the potential loss is considerably less than the potential losses related to the underlying asset alone.

Investors seeking a way to invest with a low barrier to entry can purchase a related derivative at a low price point to recognize capital gains associated with the underlying asset. Similarly, a business can invest in large amounts of commodities without storing the products.

The different types of financial derivatives can be used by businesses and individuals to avoid potential risks associated with investments and gain control of a large number of assets with a relatively small investment. Millions of derivatives are traded each year, and they can be a convenient way to achieve financial goals.

Derivatives are complex contracts that can leave investors open to third-party risks. They can be useful investments but lead to systematic risks when not used carefully. Before investing in derivatives, it's important to learn all the fundamental requirements and risks and consider seeking advice from a professional.