What is a Derivative?
A derivative is a type of financial contract whose value is rooted in the value of underlying assets such as stocks, bonds, currencies, or benchmarks. These contracts are created between two or more parties and can be traded on exchanges or over-the-counter (OTC). Derivatives are versatile instruments commonly used to either hedge against risks or speculate on price movements.
Key Features
- Dependency on Underlying Assets: Derivatives gain value from the price movements of the assets they are based on.
- Trading You Have Options: Derivatives can be traded on exchanges or directly between parties in over-the-counter markets.
- Price Fluctuations: Prices for these financial instruments are driven by the fluctuations in their underlying assets.
- Potential for Leverage: Leveraged nature increases both the potential reward and risk.
Types of Derivatives
Futures
A futures contract is an agreement to buy or sell an asset at a predetermined future date and price. Futures are standardized contracts traded on exchanges. They are often used to hedge risk or speculate on the price of an underlying asset. Example: Company A buys a futures contract for oil to hedge against rising prices. If the price rises, the contract stabilizes Company A’s expense, potentially allowing resale for profit.
Forwards
Forward contracts are similar to futures but trade over-the-counter, allowing for customized terms and settlements. The non-standardized nature of forwards increases counterparty risk. Example: By tailoring terms of a forward contract, parties manage unique needs but face higher risks of default.
Swaps
Swaps involve exchanging one type of cash flow for another. They can switch variable interest rates with fixed ones, among other uses. Example: Company XYZ uses an interest rate swap to switch its variable loan payment to a fixed 7% rate, mitigating future interest rate risks.
Options
Options provide the right, but not the obligation, to buy or sell an asset at a set price before a specified date. Example: Buying a call option allows an investor to purchase a stock at a fixed price even if its market value rises. Similarly, a put option can protect against a falling stock price.
Benefits and Drawbacks
Benefits
- Lock in Prices: Fixing asset prices against market volatility promotes business stability.
- Hedging: Mitigate adverse price movements in underlying assets.
- Margin Trading: Using borrowed funds makes them accessible with limited initial costs.
- Leveraging Positions: Increase potential ROI but also risks torrential losses.
Drawbacks
- Valuation Challenges: Derivatives depend on underlying asset prices and are sensitive to several external cost factors.
- Counterparty Risk: Particularly in OTC contracts, where default risks might occur.
- Complexity: Inherent complexity makes them tricky even for seasoned investors.
- Sensitivity: Influenced by market sentiment and supply-demand factors.
Commonly Used Terms
- Underlying Asset: Core asset which a derivative’s value is based upon.
- Hedging: Strategy to mitigate risk associated with an asset’s price movement.
- Speculation: Engaging in risky financial transactions hoping for significant returns.
- Leveraged Instruments: Financial vehicles amplifying both gains and risks.
Pros and Cons Summary
Pros
- Lock in prices
- Hedge against risk
- Can be leveraged
- Diversify portfolio
Cons
- Hard to value
- Subject to counterparty default (if OTC)
- Complex to understand
- Sensitive to supply and demand factors
Conclusion
Derivatives serve multifaceted roles in the financial markets by providing ways to hedge risk and speculate on price movements profitably. While they offer massive opportunities for leveraging positions and potentially higher returns, one must remain vigilant about the associated risks such as counterparty default, valuation complexities, and leverage risks.
Related Terms: underlying asset, hedging, speculation, leveraged instruments.
References
- CME Group. “About CME Group”.
- CME Group. “Crude Oil”.
- Bank for International Settlements. “OTC Derivatives Statistics at End-June 2021”.
