Derivative: What is it?

Patrick Curtis

Reviewed by

Patrick Curtis WSO Editorial Board

Expertise: Investment Banking | Private Equity

A derivative is a type of financial security or instrument that is essentially a financial contract between two or more parties whose value is derived from another asset, index, or interest rate (also known as the underlying asset). They are frequently used for speculation, by increasing exposure to price movements and hedging of risk, by reducing exposure to price movements). The most common types of these instruments are:

OTC Derivatives Chart - Chart displaying OTC derivatives notional amount outstanding by risk category

The market for these securities is vast and extremely liquid, but also very hard to quantify as most are sold over-the-counter (OTC), meaning off-exchange, and therefore are not regulated. There are few publicly-traded varieties of these securities, such as options and futures, which are traded on exchanges such as the Chicago Mercantile Exchange (CME). It was estimated by the BIS that the total market size for these instruments would be worth "$840 billion at the end of 2020, the highest level observed since 2010", in comparison to a global GDP of ~$85 trillion at the time.

They are one of the three main types of financial instruments, with the other two being equity (stocks or shares) and debt (bonds and mortgages).

These securities generally allow investors to earn large returns from small movements in the underlying asset's price. Since they are highly leveraged instruments, one should be extremely careful while using them as they increase the potential for risks and rewards when compared to directly investing in their underlying assets/indexes.

Trading Chart - Example of price going down

Financial Derivatives: How do they work?

They are contracts, not actual assets. In simple terms, they work by having two or more parties agree to exchange some underlying asset in the future at a specific price. This means there is no immediate exchange of assets or capital, but simply a contract to exchange them at some point in the future.

For example, a futures contract about gold doesn't involve any party buying or selling gold, but instead, its value derives from the future cost of buying and selling gold. Note that the buying and selling of gold dictate the behavior of its price and hence, they get their value from the behavior of the underlying asset (in this case, gold).

This explains why investing in these securities is riskier than buying the underlying assets directly, such as stocks. There exists volatility in their price originating from the volatility in the price of the underlying asset (e.g. buying and selling gold), which is greatly amplified by the leverage involved in the buying and selling of these securities.

Regardless, there is still a lot of capital moving through the use of these instruments which begs the question: what are the associated risks and rewards?

Derivatives in finance: Risks vs. rewards

To understand the risks and rewards involved with these securities, recall that they are frequently used for hedging and speculating. Hedgers and speculators essentially form the two most prominent market players for these instruments.

Hedgers are underlying asset owners who want to protect themselves from the risk of future price fluctuations whereas speculators are those who take on this risk by taking positions in these contracts based on their conviction about the future price movements of the asset. Essentially, hedgers own an asset and are worried that the price will change while speculators may not own the asset but predict the price will go up/down and would like to profit from this fluctuation. These contracts provide exposure to a unique set of risks and rewards to both hedgers and speculators.

For hedgers, the advantages are its ability to:

  • Mitigate risks
  • Hedge against unfavorable movements in rates
  • Lock-in selling prices
  • Ensure profit

The risk for hedgers is that if the price of the underlying asset were to move to a favorable position, they would not be able to maximize their gains as they have already locked their selling prices using these instruments.

Similarly, for speculators, the rewards are:

  • Locked-in buying/selling prices
  • Potentially large profit margins using low levels of capital
  • Ability to participate in certain markets without owning the underlying asset

The risk associated with using these securities for speculators is if the price movements start to move in the opposite direction of their predicted price, they will start losing money.

A risk that applies to both hedgers and speculators is counterparty risk which is when one of the parties involved in the contract defaults, though this is less prevalent in public trading exchanges than OTC markets due to stricter regulation. In addition to that, the highly volatile and leveraged nature of these securities also makes them inherently riskier than purchasing unleveraged positions in normal assets and shares.

Risk Warning - Sign showing words use at own risk

Financial derivatives example

A farmer owns a flock of sheep and sees that the market price for wool is constantly fluctuating between $50-100/kg. Afraid that the price may go down next year when he shears his sheep, he signs a contract with a broker (the middleman between investors and sellers) to have his wool bought at a certain price ($70/kg) next year.

There are two possible scenarios for the following year that impacts both parties.

If the price of wool rises to $100/kg next year, then investors (speculators) gain $30 per kilogram while the farmers (hedgers) only gain the difference between $70 and the cost of producing each kilogram of wool.

However, if the price of wool drops to $50, the farmers still gain the same amount of profit from the previous scenario but the investors now lose $20 per kilogram of wool as they agreed to purchase wool at $70/kg.

As profit for one party is a loss for the other, these trading in these securities is usually called a zero-sum game.

Here is a video giving a brief explanation of how they work as well as an overview of their different types:

Types of derivative securities

There are various types of derivative instruments, all with their own purpose and mechanism to suit the needs of investors.

The market for these instruments is one that continues to grow despite already being much larger than the regular asset markets, offering products to fit nearly any investment need or risk tolerance. The most common types of such securities are futures, forwards, swaps, and options.

Forward contracts

Forward contracts, also called "forwards" are contracts between two or more parties to buy or sell the underlying asset on any future date for a price agreed upon at the time of entering into the contract. Forwards are traded OTC and not on exchanges, unlike other types of derivative securities like futures. This is because, unlike futures, forwards are not standardized agreements and hence the terms between different forward contracts vary significantly, making it hard to trade over a public exchange.

Since forwards are traded OTC, they can be considered decentralized and completely customizable based on the requirements of the participating parties. Aspects of the contract that can be adjusted include the terms of the agreement, size, and settlement process (such as having a cash settlement rather than transferring ownership of the underlying asset). In exchange for this increased freedom in customization, forwards carry a greater degree of counterparty risk for all parties since they are not traded on exchanges.

Additionally, this counterparty risk can be compounded if parties in a forward contract offset their position with other counterparties as more traders become involved in the contract (e.g. a speculator makes a deal with one trader, and then proceeds to negotiate an offer with another trader that involves the first deal, thus introducing a third party to the first deal between just two parties).

Futures

Futures are essentially standardized forward contracts which are traded through any regulated exchanges. The difference between forwards and this type of contract is that futures are uniform and traded on exchanges whereas forwards are highly customizable and traded OTC.

Both forwards and futures are a commitment to buy or sell the assets during or at the time of expiry of the contract. This exposes forwards and futures contract holders to theoretically unlimited gain or loss. However, since futures are traded on exchanges, the parties involved are obligated to fulfill the contract through a commitment to buy or sell the underlying asset.

While the previous example was centered around hedgers and speculators as the parties involved, there can also be contracts where both parties are speculators.

For instance, if two traders wanted to benefit from price fluctuations of an asset (where one trader believes the price will go down and the other thinks the price will go up), they would both enter the contract but with different positions (short and long, respectively). Hence, if the price of the underlying asset increases, the short trader will suffer a loss while the long trader will profit and vice versa if the price decreases.

Formal Discussion - Two people in formal wear talking in meeting room

Options

Traders take positions in long positions in option contracts due to the potential of unlimited gains but restricted losses, unlike futures and forwards which provide unlimited gains and losses to both sides of the trade (long or short). Options give the right to buy or sell the underlying asset, but not the obligation to do so on or before a specific date mentioned for an agreed-upon price while futures require the trader to buy or sell by the expiry of the contract. These option contract rights are bought by paying a premium.

There are two types of options:

  • American options - allows holders to buy/sell the underlying asset any time before or on the day of expiration.
  • European options - allows holders to exercise the option rights only on the day of expiration.

The option buyer pays the premium and buys the right, but has no obligation to buy or sell the underlying asset. The option writer is the counterparty, who receives the premium and has the obligation to buy or sell when the option buyer exercises his right.

Option buyers have the opportunity to realize unlimited profits, but limit their loss to the premium they pay to option writers. On the other hand, option writers have exposure to unlimited losses but a limited gain in the premium they receive.

Basically, a trader who takes a position in an option contract pays the option writer a certain amount to be able to buy or sell the underlying asset by the expiration date if they want to.

Options contracts can be categorized into two main types: call options and put options. Call options give the buyer a right to buy an underlying asset while put options give the buyer a right to sell an underlying asset.

Using an example to explain how call options work, let's say a trader wants to buy 100 shares of a stock worth $20 per share as they think the price will increase. However, they are not certain of this prediction so they decide to pay a premium of $40 to buy a call option that gives them the right to purchase the shares at $20. As a result, if the price of the shares rises, the trader can use the contract to buy 100 shares at $20 and sell them at a higher price (e.g. $30), bagging the profit after paying for the premium (i.e. $(30 x 100) - $40). If the price goes down, the trader can buy the shares at a lower price, since exercising the contract does not make sense. 

To illustrate how put options work, we will use the previous example of the trader, except now they own 100 shares of a stock where each share is worth $20. The market is very volatile, which makes them worried about the possibility of losing money. To offset this risk, they can hedge their position by buying a put option contract which gives them protection against downside risk, owing to a decrease in stock prices, for a premium.

The way it works is that they pay the premium of $40 on a put option covering 100 shares, for example, allowing them to sell their shares at $20 (the strike price) until a certain future date (the expiration or exercise date). Hence, the trader will not make any loss for a decrease in price below the strike price (let's assume $10 for the sake of this example), giving this strategy the name "protective put" since it protects them from loss on the shares they own. If the price of the shares increases, they can profit from selling these shares at a higher price - rather than using the put option - and only lose a little money by paying the premium (i.e. ($30 x 100) - $40).

Since that was a lot of information to digest, here is a good video with a detailed explanation of how options work:

Swaps

Swap contracts allow different parties to exchange cash flows (exchanging cash flow from one underlying asset for another), which usually involves the exchange of a fixed rate cash flow for floating rate one. The most popular types of swaps are interest rate swaps, commodity swaps, and currency swaps. For instance, an interest rate swap could be used by a trader to change their exposure from a fixed interest rate loan to a variable interest rate loan, or vice versa.

Although swaps are one of the most common types of derivatives, they are widely used by businesses rather than retail traders, and hence are not as popular amongst the general population.

Using the most common type of swap - an interest rate swap - as an example, if a business A borrowed some money on a loan that is currently 5%, they may be worried about rising interest rates, which will affect their variable-rate loan as they will need to pay more in terms of interest. In order to offset this risk, they can enter into a swap with another company B that agrees to exchange payments owed on company A's variable-rate loan for payments owed on company B's fixed-rate loan of 6.5%.

Therefore, the two companies essentially swap the interest rates on their loans, where company A is attempting to hedge its risk while company B would be speculating that the interest rates will not increase above their initial fixed rate of 6.5%. If interest rates fall, company B will benefit from the swap whereas, if interest rates rise above 6.5%, company A will benefit.

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Patrick Curtis is a member of WSO Editorial Board which helps ensure the accuracy of content across top articles on Wall Street Oasis. He has experience in investment banking at Rothschild and private equity at Tailwind Capital along with an MBA from the Wharton School of Business. He is also the founder and current CEO of Wall Street Oasis This content was originally created by member WallStreetOasis.com and has evolved with the help of our mentors.