What is a Derivative?

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Definition:

A derivative is a financial contract that bases its value on the changes in price or statistical fluctuations of something else — referred to as the underlying asset.

🤔 Understanding derivatives

A derivative is a contract that bases its value on something else. Derivatives derive value from price movements, events, or outcomes of an underlying asset. Underlying assets are usually securities like stocks, bonds, index funds, mutual funds, and commodities. Derivatives can also track numerical indexes or statistics based on events and outcomes outside the financial realm — like the weather. Derivative financial products come in different forms and do different things. Some try to secure a future price of a commodity, such as wheat, to help limit the risk of future price increases. Others guess on future stock price movements to seek a profit. Still, others swap currencies and interest rates to gain a comparative advantage. The important thing to remember about derivatives is that without underlying assets they can’t exist.

Example

Extreme weather changes can affect a utility company's bottom line. Weather derivatives offer companies whose business value is dependent on weather conditions a way to hedge against the risk of severe or unexpected weather changes. Some weather derivatives get their value from changes in temperature. For example, a weather derivative based on temperature could pay a contract holder if the temperature stays above a certain level for a specific length of time, which might increase electricity costs. Such a contract could hedge the risk of volatility of energy costs during times of increased temperatures.

Takeaway

Derivatives trading is like an escalator compared to the staircase of the traditional stock and bond markets...

But escalators go both ways. Derivatives can offer investors more opportunity for speculation and increased gains. But this opportunity also exposes traders to escalated losses. Traders who are particularly risk-averse may be better off taking the stairs.

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What is a derivative?

Derivatives are financial products that derive their value from something else, such as the price movements of underlying financial assets. An underlying asset can be many things, but it commonly refers to stocks, bonds, commodities, currencies, interest rates, and market indexes. However, firms can also create derivatives to speculate on events not directly related to the trading markets that can have a financial impact — such as the weather or shipping costs.

The majority of derivatives trade over the counter (OTC) — outside of formal exchanges through dealer networks. Derivatives are typically used by investors to hedge risk and speculate. Hedgers seek to limit risk by using derivatives as insurance policies against loss. The opportunity for leveraging profit using derivatives drives speculation. Both uses require trading knowledge as derivatives are complex.

What are the types of financial derivatives?

Futures

Futures contracts allow a buyer (long position) and a seller (short position) to set a price today for the future exchange of a commodity (like oil, gold, or wheat) or financial asset (like stocks and foreign currencies). The buyer and seller agree on a fixed price, quantity, and future delivery or settlement date of an underlying asset. Futures contracts then track the price of the underlying asset. Daily gains or losses are added to or subtracted from a trader’s account at the close of each trading day. Futures can be cash-settled or sold at any time by offsetting (taking the opposite position) before they expire.

Futures contracts are regulated, standardized, and traded on a futures exchange. To enter a position on a futures contract, you only have to deposit a percentage (initial margin) of the contract’s total value into your futures broker account. But you have to keep a certain amount in your account (maintenance margin) to cover any losses.

  • Forwards: A forwards contract is like a futures contract. But forwards are not standardized or regulated and are only traded in the over-the-counter (OTC) markets, usually between institutional investors or large organizations. Forwards don't trade on futures exchanges by retail investors. Unlike futures, the terms of forwards are negotiable. Counterparties can create forwards on a wide variety of underlying assets or variables.

Options

An option transfers you the right to buy (call option) or sell (put option) an underlying asset at a given price (strike price) for a given time (until the option expires). You pay a fee (premium) per share to lock in the strike price. Options are different than futures because with options you have the right to buy or sell, but not the obligation. You’d only exercise the option if you were on the winning side of the money. If you choose not to exercise the option, you’d lose the premium price per share you paid upfront to lock in the strike price.

Swaps

Swaps are contracts to exchange cash flows or financial terms and only trade in the over-the-counter (OTC) markets. There are many different kinds of swap derivatives. Here are two common examples:

  • Interest rate swaps: Different companies borrow money with different interest rate terms. Sometimes borrowers may want to exchange interest rate types with each other. Say Company A gets a $4M loan with a variable or floating interest rate (rate can change daily) while Company B receives a $4M loan with a fixed interest rate (rate doesn't change). A swaps bank charges each company a percentage of the interest to trade interest rate types for the two companies, which can create better interest terms for each company. In an interest rate swap, only the interest payments are exchanged, not the principal (the amount borrowed).
  • Currency swaps: A currency swap is when two parties trade the principal (amount borrowed) and interest of a loan of different currencies with each other. Currency swaps allow companies to make cross-border capital investments without being exposed to exchange rate risk. Say a US company wanted to create a subsidiary in Germany, and a German company was interested in investing in a project in America. They could create an agreement to borrow in their local markets and swap currencies through a currency swaps bank, which would take a slight percentage of interest from each of them.

What is the use of derivatives?

Investors use derivatives to either hedge risk or speculate — Hedging risk means to limit risk. Derivatives may offset the negative impacts of future price increases, changes in interest rates, foreign currency rates, and even chances that a borrower will default on a loan.

Investors also use derivatives to speculate for profit. The spot market (the market today for trading assets in real-time) and the derivatives market (a market related to the future) have a relationship based on arbitrage. Arbitrage happens when an investor buys and sells securities or financial products to take advantage of price differences to try and make a profit. The derivatives market opens up more opportunities for arbitrage.

What is the difference between a security and a derivative?

The distinction between a security and a derivative can be hard to make because people often refer to derivatives as a type of securities — which is technically correct. (The term “securities” refers to a broad range of financial instruments.)

What are the advantages and disadvantages of derivatives?

The derivatives market includes an almost uncountable variety of financial instruments. Advantages and disadvantages will vary depending upon the type of derivative. They will also vary between companies or financial institutions trading on the over the counter markets (OTC) and retail traders trading in regulated exchanges.

Here are some of the general pros and cons for retail traders:

Advantages:

  • Derivatives can help hedge risk if used to cover the opposing position of a trade
  • Derivatives offer more significant speculative opportunities (which also increases risk)
  • The low margins of futures and options create greater leverage (you can gain more, but you can also lose more)

Disadvantages:

  • Derivatives can be complex and difficult to understand
  • Derivatives can be dangerous in the hands of inexperienced traders — due to the complexity you can easily make poor decisions and lose money
  • The high leverage of futures and options derivatives can expose traders to unlimited risk

Please note that the approaches discussed in this article are very risky and not recommended for the average investor. They are also very complex so require extensive education before investing. Trading derivatives is not suitable for all investors. It is highly speculative and could result in significant losses.

How big is the derivative market?

The global derivatives market is enormous. The 2019 Bank for International Settlements (BIS) Triennial Central Bank Survey estimates that the global foreign exchange and over the counter (OTC) derivatives markets are both more significant and diversified than ever before, partly because of the increase of electronic and automated trading. Electronic trading reduces transaction costs and opens up markets to greater participant diversity.

Because derivatives contracts derive their value in different ways from their underlying assets, the actual size of the derivative market is challenging to estimate. Two measurements that stand out are notional value and gross market value.

  • Notional value: Notional values are values of the underlying asset, but they’re looked at in different ways for different types of derivatives. For example, for futures contracts, notional amounts are the quantity of the asset multiplied by the spot price (the price in the contract). But for interest rate swaps, notional values are the amount of the principal — the money used to calculate the interest payments. According to the BIS, global notional amounts of OTC derivatives were $640T in 2019.
  • Gross market value: Gross market value adds all absolute values of OTC derivatives, both positive and negative, at market values, on the date reported. The gross market value of OTC derivatives was $12.6T in 2019, according to the BIS.

Keep in mind, options trading has significant risk and isn’t appropriate for all investors — and certain complex options strategies carry even additional risk. To learn more about the risks associated with options trading, please review the options disclosure document entitled Characteristics and Risks of Standardized Options, available here or through https://www.theocc.com. Investors should absolutely consider their investment objectives and risks carefully before trading options. Supporting documentation for any claims, if applicable, will be furnished upon request.

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The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory.

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