Derivatives are investment contracts valued against a benchmark, asset pool or specific underlying asset, traded between at least two parties.
Traded contracts can relate to any asset, although these securities are most commonly linked to stocks, bonds, forex, interest rates, market indices and commodities.
Over-the-counter derivatives comprise the bulk of the unregulated trading market, but exchange-traded derivatives are standardised and less risky. Derivative pricing depends on the associated asset and value fluctuations and can be used as a hedge against risk exposure or to speculate.
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If traders invest in derivatives with added broker leverage, it increases both the calculated risk and reward.
Derivative Trading Explained
Investors trade derivatives as a financial security product to access a market or trade specific underlying assets with pricing based on the asset or asset pool – the way a derivative contract derives value is what makes it different from other financial contracts.
Traders can use derivatives to speculate on future asset prices or hedge a risky position. They may invest through regulated exchanges or over-the-counter (OTC) with one, or several other parties, although broker-facilitated deals are generally safer.
OTC derivatives are inherently riskier, because an independent party is more likely to default rather than someone trading on a derivatives exchange.
Derivatives were created to help balance the exchange rate system for global traders as a way for international investors to account for forex fluctuations between different currency prices.
Example of derivative trading
Suppose an investor in one country has all their investment assets in their domestic currency but buys shares in another denomination. In that case, they are taking on an exchange rate risk because the stocks they hold could fall in value based purely on the exchange rate.
Those risks could eat into real-world profits generated from capital growth or selling the stocks. The trader can therefore use derivatives to speculate in this direction without holding the currency or having any forex assets within their portfolio.
If the currency exchange rate moves against them, they will have offset the potential loss by taking out a derivative to the value they predict exchange rates might fluctuate.
Brokers and exchanges also provide derivatives leverage, which in effect, means borrowing against a margin, or deposit and multiplying the value – and potential gain or loss.
Different Derivative Types And Classes
Derivatives apply to countless transactions, even to speculate on non-financial events, like the weather.
Investors use derivatives to:
- Manage risk
- Leverage a position
- Speculate on the markets
There are two derivative product classes, lock and option. A lock derivative, such as swaps, forwards, or futures, enters both parties into a binding contract until it reaches maturity, with pre-agreed terms.
Options derivatives focus on products such as stock options and give the trader the right to buy or sell the security or underlying asset before the option expires – although they have no obligation.
Forwards
Forward contracts, shortened to forwards, refer to a contract traded OTC that works similarly to futures. The buyer and seller agree upon the contractual terms, the size of the trade, and how it will be settled on expiry.
The traders will agree to price a future asset purchase and delivery and are obligated to buy or sell the underlying asset at the agreed value, regardless of what happens to the current market price before they reach the maturation date.
Because forwards are OTC rather than exchange-traded, they are risky, since counterparty risks include credit exposure, where one contractual party cannot fulfil their obligations and defaults.
Traders can offset forward positions with other contracts – although this increased complexity can also exaggerate exposure.
Futures
Futures work like forwards but are standardised and exchange-traded. Both parties still agree to buy or sell the underlying asset at a future price and on an agreed expiry date, although a regulated exchange facilitates the contract.
Investors use futures to take positions on financial instruments or commodities and can hedge portfolio risk or speculate on asset prices based on their market knowledge and forecasts.
Global companies and traders use futures to lock in essential supplies or forex at a predetermined rate to hedge the risk that prices will rise higher than their futures contract rate.
For example, a steel company might trade futures on a per-tonne rate several months in the future, ensuring they have a guaranteed, fixed price for their raw material supplies. There is the option to sell futures before expiry if the company no longer requires the steel – any accrued profit is realised and received on the sale, less the original trade cost.
Settling futures contracts
If a trader does not wish to wait for the futures contract to expire and take delivery of the underlying asset, or vice versa for the seller, they can unwind the contract with an offsetting agreement before they reach the term end.
This option is common where futures are used as investment speculation, and neither party wants to deliver or receive the underlying asset physically.
Derivatives are commonly cash-settled, so the trader receives their profit or is credited the value of the loss through their trading account. Likewise, futures contracts such as interest rate futures, volatility futures or stock index futures are typically cash-settled.
Swaps
Swaps are derivative contracts where traders swap one cash flow asset for another, such as trading loans with varying interest rates. As an example of an interest rate swap:
- Trader A has a loan with a six per cent variable interest rate and anticipates rising interest rates will increase the cost of the debt.
- They swap their loan with Trader B for a fixed-rate loan product with a seven per cent rate, paying the seven per cent to the other party, and vice versa.
- When the swap is agreed, Trader A pays Trader B the one per cent difference – the variance between the two swap rates.
If the interest rate drops and the variable interest rate falls to five per cent, Trader A pays Trader B the two per cent difference.
However, suppose rates rise as they predict and reach eight per cent. In that case, Trader B pays Trader A the one per cent difference – thus swapping a variable interest rate for a fixed interest rate, regardless of how underlying base rates fluctuate.
Swaps are also used to offset exchange rate risks and are popular for traders managing cash flow exposure and mortgage bond default risk.
Options
Options are another form of derivative and work like futures where two parties agree to buy or sell an asset at a predetermined price and on a future date. The difference is that options mean the buyer is not obligated to proceed – but they have the option if they wish to use it.
These contracts can be bought or sold, and although US options can be exercised at any point, up to or at expiration, traders can only execute EU options on the expiry date.
The seller is contractually obliged to fulfil the contract terms if the buyer exercises their option, but this only works one way, and the buyer can choose not to.
For example, an investor could buy an option where they lock in a stock sale price per share worth their current portfolio holding on a future date. They do not have to sell at that price, but if the shares fall in the meantime, they can go ahead and offset the potential loss.
Investors use protective put options to safeguard the possibility that a stock becomes devalued. They need to pay the cost of the options contract, although they may consider this worthwhile since the protection provided could be worth substantially more.
Derivatives – What Are They And How Do They Work FAQ
Derivatives can be beneficial for traders looking to hedge potential movements in stock prices or rates, mitigate risk exposure, and secure guaranteed prices for future trading.
The transaction cost is often much smaller than the hedge, and traders can margin trade and use leverage borrowed from a broker to maximise the possible profit of the transaction – which reduces any potential loss.
Derivatives are valued based on the underlying asset’s price, making it difficult to ascertain a fair cost. OTC derivative trading is also exposed to counterparty risk, where another party to the contract could default.
Investors need to evaluate the cost of retaining the underlying asset, interest rate fluctuations, and how likely their position will change before the expiry date.
A derivative contract has no value, so it can quickly change in viability if markets shift, and a heavily leveraged derivative can create substantial losses.
The idea behind derivatives is that they act as securities, with value derived from whichever asset the contract is based on. For example, an interest rate derivative will be based on interest rate levels and potential changes before the contract ends.
Derivatives include a range of financial contracts, such as options, futures, forwards, and swaps.
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