Derivatives

Overview of Derivatives

A derivative is a financial instrument whose value is based on one or more underlying assets.

Learning Objectives

Differentiate between different types of derivatives and their uses

Key Takeaways

Key Points

  • Derivatives are broadly categorized by the relationship between the underlying asset and the derivative, the type of underlying asset, the market in which they trade, and their pay-off profile.
  • The most common types of derivatives are forwards, futures, options, and swaps. The most common underlying assets include commodities, stocks, bonds, interest rates, and currencies.
  • Derivatives allow investors to earn large returns from small movements in the underlying asset’s price. Conversely, investors could lose large amounts if the price of the underlying moves against them significantly.
  • Derivatives contracts can be either over-the-counter or exchange -traded.

Key Terms

  • derivative: A financial instrument whose value depends on the valuation of an underlying asset; such as a warrant, an option, etc.
  • notional: Having descriptive value as opposed to a syntactic category.
  • margin: Collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty.

Overview Of Derivatives

A derivative is a financial instrument whose value is based on one or more underlying assets. In practice, it is a contract between two parties that specifies conditions – especially dates, resulting values of the underlying variables, and notional amounts – under which payments are to be made between the parties.

Derivatives are broadly categorized by the relationship between the underlying asset and the derivative, the type of underlying asset, the market in which they trade, and their pay-off profile. The most common types of derivatives are forwards, futures, options, and swaps. The most common underlying assets include commodities, stocks, bonds, interest rates, and currencies.

Derivatives are used by investors for the following:

  • To provide leverage, such that a small movement in the underlying value can cause a large difference in the value of the derivative.
  • To speculate and make a profit if the value of the underlying asset moves the way they expect.
  • To hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to the underlying position and cancels part or all of it out.
  • To obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives).
  • To create option ability where the value of the derivative is linked to a specific condition or event (e.g. the underlying reaching a specific price level).

The use of derivatives can result in large losses because of the use of leverage. Derivatives allow investors to earn large returns from small movements in the underlying asset’s price. Conversely, investors could lose large amounts if the price of the underlying moves against them significantly.

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World Wealth Vs. World Derivatives: This graph illustrates total world wealth versus total notional value in derivatives contracts between 1998 and 2007.

Types

In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in the market.

Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, exotic options – and other exotic derivatives – are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is mostly unregulated with respect to disclosure of information between the parties.

Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange. It acts as an intermediary to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee.

Common Derivative Types

A forward contract is a non-standardized contract between two parties to buy or sell an asset at a specified future time, at a price agreed upon today. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party.

A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold. On the other hand, the forward contract is a non-standardized contract written by the parties themselves. Forwards also typically have no interim partial settlements – or “true-ups” – in margin requirements like futures, such that the parties do not exchange additional property, securing the party at gain, and the entire unrealized gain or loss builds up while the contract is open.

Swaps are derivatives in which counterparties exchange cash flows of one party’s financial instrument for those of the other party’s financial instrument. For example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest (or coupon) payments associated with the bonds. Specifically, the two counterparties agree to exchange one stream of cash flows against another stream. The swap agreement defines the dates when the cash flows are to be paid and the way they are calculated. Usually at the time when the contract is initiated at least one of these series of cash flows is determined by a random or uncertain variable such as an interest rate, foreign exchange rate, equity price or commodity price.