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What is a Derivative? | Definition | Simply Explained

What is a Derivative?
Kadi
Arula
Updated: 21 Jun, 2022
18 mins read

A derivative is a financial term often used to refer to a general asset class; however, the actual value derives from the underlying assets. If you are considering diversifying your portfolio by trading derivatives, it’s a good idea to get a thorough understanding beforehand, as higher risk and more complex processes are involved. This guide will explain how they function, the most common derivative contract types, and the benefits and risks of trading derivatives.

What is a derivative?

A derivative is a financial contract between two or more parties – a buyer and a seller – that derives the value of its underlying asset. Specifically, a derivative contract gets its value from various asset classes such as commodities like wheat, gold, or oil, financial instruments like stocks, bonds, market indexes, currencies, or any other asset type. 

Underlying assets of derivative contracts. Source: ICICIdirect.com

Prices in these contracts or agreements derive from the price fluctuations of the underlying assets. When the cost of the underlying asset changes, the contract value changes too.

The four most common derivative contract types are:

  1. futures;
  2. options;
  3. swaps;
  4. forwards

Even though derivatives come with many advantages, hence their popularity among traders, they aren’t for beginner investors due to the higher risk involved. Indeed, many derivatives are leveraged, which means investors can use borrowed money to try to double their profits. 

Important: For leveraged investments, traders need only a small amount of their equity of the total asset value to open a trade. Even though leverage can multiply your profits, it can also multiply losses if the transaction isn’t successful. Therefore, you must thoroughly understand what derivatives are and how they function beforehand

Recommended video: Financial Derivatives Simply Explained

Derivatives explained by ‘TheRestOfUs

Beginners’ corner:


How are derivatives traded?

Depending on the contract type, derivatives are traded either on an exchange or over-the-counter (OTC), and some contract types come with higher risk than others. For example, commodity futures trade on one of the largest derivatives exchanges, the Chicago Mercantile Exchange (CME).

Derivatives are commonly used by two types of investors: hedgers and speculators

Hedgers are institutional investors whose main aim is to lock in the current prices of a commodity through a futures contract, one of the most common types of derivative contracts. Their main objective is to exchange or receive the contract’s underlying asset, the physical product.

On the other hand, speculators are individual investors whose main aim is to profit from price fluctuations of the underlying asset in the market and give leverage to their holdings. They are not interested in actually receiving the underlying asset.

Trading on an exchange vs. over-the-counter (OTC)

The fact that not all derivatives are traded on exchanges means that the risk associated with some of them is greater. Whereas derivative contracts traded on exchanges are regulated, the ones exchanged over-the-counter aren’t, which means counterparty risk to investors. 

Counterparty risk is the possibility that either party that has entered the trade could default on the contract. It means either the buyer or the seller can’t make the required payments and oblige to the contractual agreement.  

That is why investors should consider the credit score of each party, as it can usually reflect how high the counterparty risk is before entering the trade. So, even though investors can profit more on an OTC derivative, more risk is involved. 

4 common types of derivative contracts

Derivatives can pull value from any underlying asset based on several use cases and transactions – exchanging goods and services or financial securities in return for money.

As the derivatives market grows, investors can use it to fit their risk tolerance, as some derivative contracts carry a higher risk than others. There are four types of derivative contracts, and below, we’ll explain in detail what each is, their functionalities and the specific benefits and risks they carry. 

Different derivative contract types are commonly used by companies to lock in current prices of commodities or individual investors to speculate on price swings to earn a profit. 

The four most common derivative types are futures, options, swaps, and forwards.

1. Futures 

Futures contracts oblige two parties, a buyer and a seller, to either buy or sell the underlying asset at a fixed price at a set date in the future. Futures are binding for both sides, meaning that the buyer has to buy and the seller has to sell even if the trade goes against them. 

Futures trade on exchanges and all investors need an approved brokerage account, so there is less risk the other party will default. However, they are leveraged, which means the investor doesn’t have to invest the total value of the assets to enter a trade. It can multiply profits in case of a successful trade but also amplify losses if it isn’t unsuccessful.

For example, brokers ask for the initial investment called the initial margin, set by the futures exchange, usually 3% to 10% of the total value. The broker would loan you the rest of the contract value. 

Your broker will set the maintenance margin, which is the minimum amount that should be on your account throughout the contract, usually around 50% to 75% of the initial margin. If the trade goes against you and the amount drops below the maintenance margin, your broker sends a margin call, requiring you to deposit more money to the account. 

Futures are commonly used by two types of investors: hedgers to lock in current prices of commodities they need in their production process, or speculators whose main aim is to earn a profit from price swings of the underlying assets. Speculators aren’t interested in receiving the physical products and close their position for cash settlement.  

Hedgers – Who are they?

Hedgers are institutional investors that use futures contracts to guarantee current fixed prices of a commodity such as oil or wheat at current prices in the future. 

Institutional investors don’t trade futures to earn a profit; they enter the contracts to receive the physical product at a lower price to cut operational costs, aiming to lower the risk of rising prices.

For example, the buyer who works at a large airline knows they need a lot of oil to operate and assumes the price will rise in the future. They enter a futures contract with the oil supplier to lock in current prices for some time to guarantee a fixed cost.

On the other hand, the seller can benefit from locking in sales for their product. For instance, a wheat farmer thinks prices and demand for wheat will drop in the next six months. They enter a futures contract with a company that needs it to guarantee their sales at the current price.

Speculators – Who are they?

Speculators are individual traders who aren’t interested in the physical product, and their main aim is to profit from the underlying assets, such as stocks or commodities, and price movements. 

They enter a futures agreement speculating that the price will either go up – open a long position, or down – a short position. Speculators close their position before the contract expires and before any product changes hands for a cash settlement.

2. Options 

Options contracts are derivatives that give both parties the right to buy or sell the underlying asset – stocks, bonds, commodities, or other financial instruments at a fixed price for a finite period until the contract expires. 

Whereas futures oblige the investors to buy or sell at a set price, options contracts give them the option to do so. Options are commonly used as stock options given to employees as an incentive instead or on top of their salary.

Options are usually bought and sold via online brokers, generally used by individual investors. Furthermore, options contracts allow investors to reduce risk on their portfolio by locking in the option to purchase stocks at a later date for the current price. 

There are two main types of options: put options and call options. Put options are a bet by the buyer that the price will fall, and a call option is that the price will rise. 

The price determined in the contract at which the underlying asset can be bought (call options) or sold (put options) is called the strike price, also known as the exercise price, as traders can exercise their right to buy or sell at that cost. 

The strike price is determined by looking at the intrinsic value – its actual value by objective financial analysis, or time value – based on the underlying asset’s volatility and time until the contract expiry, rather than its current trading price.

Each option has two sides, a buyer and a seller: 

Put option buyer: has the right to sell an asset at a strike price; 

Put option seller: has an obligation to buy an asset at a strike price.

Call option buyer: has the right to buy an asset at a strike price;

Call option seller: has an obligation to sell an asset at a strike price. 

To sell the asset via an options contract, the buyer has to pay the option seller, also called the option writer, a fee called a premium. In exchange for a premium, the buyer or seller gets the right to sell or buy the asset at a predetermined price.

Put options 

A put option contract is a bet that the prices of the underlying assets will decrease, granting the buyer the right to short sell. 

When the underlying stock’s price falls, a put option will benefit in value. Put options give the option buyer the right to sell, but not the obligation to sell, the asset at a price stated in the contract (strike price) until its expiry.

The put option’s value increases when the stock price decreases and the put option’s value decreases when the underlying asset increases in value. If an investor opens a put option, they assume the underlying stock will decline in price. 

Call options

On the other hand, a call option is a bet that the price of the underlying asset will rise – the value of a call option increases when the asset price increases, and its value decreases when the asset price decreases.  

A call option gives the call option buyer the right to buy an asset at a strike price until the contract’s expiry date. For example, if the stock price has gone up, the buyer can purchase the stocks at a lower price and sell for profit. 

Two types of call options are short call options and long call options. If an investor chooses a call option, they assume the underlying stock will increase in price, whereas the seller takes a short call option.

3. Swaps 

Swaps are derivative contracts representing an agreement between two parties who want to exchange liabilities or cash flows, commonly a bond or a loan.

They can exchange predictability for risk and vice versa, primarily used by financial institutions to earn a profit – the most common type is an interest rate swap.

Swaps can offer more flexibility for each side involved. For example, if either party’s loan repayment structure or investment goals have changed, each can benefit from the other party’s cash flow stream. 

As opposed to other standardized derivative contracts like futures or options, swaps are traded only over-the-counter (OTC) and not on an exchange. Swaps are also customized and based on a mutual agreement, offering a win-win situation for both sides. 

However, as OTC trading is not regulated, swaps can also enhance the counterparty risk and risk of default, as they are executed between two private parties.

Some of the most common swaps types include: credit swaps, interest rate swaps, currency swaps, commodity swaps, credit default swaps, zero-coupon swaps, or total return swaps.

Interest rate swaps

An interest rate swap means exchanging one stream of floating interest payments for the one with a fixed-rate interest. The most common interest rate swap is trading a loan with a variable interest rate for a fixed interest rate loan.

For example, Peter, a small store owner, has taken out a loan with a floating rate of 3%, meaning that the borrowed sum can go up and down at any time. He doesn’t know how much interest he has to pay each month. 

However, Peter doesn’t like risk and wants to be able to budget easily and predict his costs. He would rather pay a fixed-rate interest on it – a fixed monthly sum with no surprise costs. 

His friend Jim, who works at a large investment bank, doesn’t mind risk and is willing to swap with him. Jim’s firm takes on the floating variable rate loan, whereas Peter will start paying a fixed-rate interest of $1,000 per month to Jim. 

If the floating interest rate ends up being lower than the fixed amount of $1,000, then Jim profits – he takes on the risk for a chance to profit from the deal. However, it can also go the other way – if the interest rate is higher, Jim pays more. Hence a swap is exchanging predictability for risk or vice versa.

Credit default swaps

Similar to an insurance contract, credit default swaps (CDS) provide the contract buyer insurance that they get their money, even if the other party they entered an agreement with cannot do so, involving three separate parties.

For example, a bank has given out millions of dollars worth of loans to thousands of people and expects all to pay back the loan in full. Some of them might lose jobs or can’t pay the money back. To counteract this risk, you can purchase a credit default swap, which acts as insurance in case of a potential default. 

For example, party A borrows money from party B, but party B is scared that party A will default and can’t repay. They purchase a credit default swap from party C, which guarantees party B that they will cover the loan if party A defaults, earning interest from the contract but taking on a risk.

Credit fault swaps were used by one of the largest investment banks, Lehman Brothers, in 2008, at the heart of the financial crisis caused by sub-prime mortgage-backed securities (MBS). After the crash, the company suddenly owed over $600 billion in debt, out of which $400 billion was by credit default swaps.

Currency swaps

Institutional investors – companies, banks, corporations, and speculators – use currency swaps and include two parties to exchange a notional principal – a theoretical interest rate value each side pays in agreed intervals. 

A currency swap is for the desired currency to get a better interest rate. Two sides take out a loan in foreign currencies but pay back each other’s loan interest rates instead. 

For example, company A based in Germany wants to expand to Australia. At the same time, company B, based in Australia, plans to broaden their operations to Germany. 

Via an exchange swap, both businesses can get a loan with a better interest rate and terms in their respective countries, getting exposure to their desired currency at lower interest rates. 

Commodity swaps

A commodity swap exchanges cash flows dependent on the underlying asset or commodity. Companies use it to hedge against price swings in the market, such as wheat, gold, or oil, allowing businesses to lock in prices of raw materials needed in their production process.

Commodity swaps are traded over-the-counter and not on exchanges, which is why they come with higher risk. These deals are often customized and created by financial services companies and have two types: fixed floating swaps and commodity-for-interest swaps.

4. Forwards

Forward contracts operate similarly to futures contracts, but the main difference is that they trade over-the-counter and not through exchanges and therefore are more customizable. 

Similar to futures, forwards are used by hedgers as well as speculators. As forwards are non-standardized, institutional investors use them more for hedging. As forwards are over-the-counter instruments, they pose a greater counterparty risk and risk of default.

For example, forwards can help manufacturers lock in current prices of agricultural products and raw material commodities like grains, livestock, or oil via futures contracts, by customizing and determining its price, end date, delivery date, item, and amount, which is otherwise limited in the case of fixed and standardized terms in futures contracts. 

Like futures contracts, futures obligate traders to buy or sell the underlying asset at a fixed price on a specified date determined in the agreement. 

Forwards contracts are settled when the contract expires, rather than at the end of the day like for futures. Just like futures, forwards are paid or settled on a cash or a delivery basis.

Advantages and disadvantages of trading derivatives

Advantages to derivative trading include the use of leverage and lower transaction fees, allowing investors to benefit from hedging risk from rising prices of commodities or profit from price movements of the underlying assets. 

However, derivatives also involve a higher degree of risk of losing money due to the use of leverage, and they come with a more complicated trading process, which is why proper understanding before trading and derivatives is crucial.

Advantages

Derivatives offer several advantages to speculators, individual investors, and hedgers or institutional investors. 

Some of the pros of derivatives trading include:

  • Lock in prices; 
  • Can be leveraged;
  • Offer exposure to a variety of asset classes;
  • Hedge against rising prices of raw materials;
  • Lock in current prices;
  • Hedge against risk;
  • Lower equity requirements to enter a trade;
  • Lower taxes;
  • Lower transaction costs;
  • Diversify portfolio.

However, these advantages come at a cost and involve a higher degree of risk. 

Disadvantages

Derivatives have no intrinsic value since the value of the contracts is derived from the underlying assets. It makes it difficult to assess the underlying asset’s actual cost accurately. 

Moreover, using leverage can cut both ways – it is both an advantage and a disadvantage. Leverage can amplify returns, but losses can also exceed the money invested. Over-the-counter derivatives contracts are also subject to counterparty risk, making them hard to predict and value.

Some of the principal risks and disadvantages of derivatives include: 

  • High interest rates (leverage);
  • Sensitive to price swings of the underlying asset;
  • Difficult to accurately assess the asset price in the contract (hard to value);
  • OTC derivatives are subject to counterparty default risk;
  • Complex trading processes;
  • Collateral calls in contracts.

In conclusion 

Derivatives are one of the largest, fastest-growing, and most dynamic financial instruments, as they generate new opportunities and can split risk between several parties. Derivative trading can offer leverage and therefore multiply profit with less equity needed. 

On the other hand, derivative instruments can also increase additional risks like counterparty default. Derivative trading isn’t for beginner investors, as more complex processes are involved, and thorough research and understanding is required beforehand.

FAQs about derivatives

What is a derivative?

A derivative is a contractual agreement between two parties, a buyer and a seller, used by a financial institution, a corporation, or an individual investor. These contracts derive value from the underlying asset, a commodity like oil, wheat, gold, or livestock, or financial instruments like stocks, bonds, or currencies.

How are derivatives traded?

Derivatives are traded either on an exchange or over-the-counter (OTC), commonly used by two different investor types: institutional investors to lock in commodity prices or individual investors to earn a profit. 

What are different types of derivatives?

The most common types of derivatives include futures, options, swaps, and forwards. Futures are used by hedgers to lock in prices of commodities or speculators to profit on price swings. Options allow investors to buy stocks or other assets at a fixed price in the future. Swaps permit two parties to exchange assets, and forwards enable investors to lock in the prices of commodities.

What are the pros and cons of derivative trading?

The main advantages of derivatives are that they offer exposure to various types of assets that can’t trade otherwise. Also standard is the use of leverage that enables multiplying profits or locking in prices to hedge risk. The downsides of derivative trading include high interest, counterparty default risk, and complex trading processes.

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Kadi Arula
Author

Kadi Arula is a professional content writer with extensive knowledge in e-commerce. She is passionate about finance and investing. Kadi enjoys assisting others in making educated choices by writing informative finance-related articles and creating detailed guides.

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