What Is a Derivative?
Updated: Aug 4, 2021
Derivatives Meaning
A derivative is a tradable instrument (like a stock CFD) sourced or ‘derived’ from the value of an underlying asset (the actual stock on an exchange). Derivatives can be imagined as a contract between two counterparties, agreeing that it mirrors a particular stock, currency, crypto, commodity, interest rates, indices or any other security’s price.
Derivatives come in many shapes and sizes. Learn what derivatives are, the difference between them, how they work, and take advantage of them.
Table of Contents
Derivatives Explained with Examples
Derivatives are a subsidiary contract to underlying financial assets (like a forex pair) to provide speculators or hedgers with greater flexibility when capitalising on market movements or reducing risk. [1]
For example, if Microsoft is importing computer parts from a company in Japan, they may seek to stabilise the price they pay for the year ahead. To achieve this, Microsoft agrees with the Japanese company, fixing the computer parts’ price for the next 12-months.
This agreement between Microsoft and its international trading partner is a type of derivative. The underlying assets are the computer parts, and the contract agreeing on the price over 12-months is the derivative.
Companies like Microsoft enter these agreements to help mitigate the risk of price fluctuations of the underlying asset. If the price of computer parts, for example, increased over the next 12-months, Microsoft would’ve saved money due to their agreement. However, if the price of the computer parts dropped, Microsoft would suffer a loss. This loss is generally considered acceptable in return to have stable, predictable costs of business.
How Derivatives Work
Derivatives allow many investors, business owners, and speculators to take advantage of an asset or group of assets’ price movements without owning them. Instead, they would hold a binding contract that agrees upon the price of that asset over a period of time.
There are many types of derivative contracts, with distinct purposes ranging from eliminating the risk from fluctuating currency exchange rates (forex CFDs) right the way to predicting future box office revenues for speculative profits (Movie or box office futures).[2]
Derivatives are purchased through a financial broker as standardised contracts (exchange-traded) or custom contracts (over-the-counter). Exchange-traded derivatives are generally traded on the Chicago Mercantile Exchange (CME) and the New York Stock Exchange (NYSE), whereas over-the-counter (OTC) derivatives are not centralised and are settled between two counterparties. [3]
Swaps Derivatives
Swaps are a form of derivative contract that allow investors or companies to exchange similar agreements. Comparable to how enthusiasts exchange Pokemon cards - each card offers different perks and abilities, enticing others to trade with each other for their unique needs.
For swaps, instead of playing cards, parties may trade various financial contracts that may be slightly different to what they currently have to meet their own financial goals. A prime example is where company ABC takes out a 10,000 USD loan, with varying interest rates of 4% to boost growth. After a few months, they grow concerns that their interest rate may rise far beyond 4% soon, so they need a plan to avoid the extra costs. Company ABC decides to solve this by creating an “interest rate swap” with another company XYZ.
The interest rate swap states that company ABC will pay company XYZ a fixed interest rate of 5% on their 10,000 USD loan. Company XYZ will pay company A the variable interest rate (which is currently 4%) that they will then use to pay the original lender.
Initially, company ABC pays a 1% higher interest rate for the luxury of a fixed rate (from 4% to 5%). But, if the variable interest rate rises to 7%, company ABC still pays 5% to company XYZ, and company XYZ would pay 7%. Irrespective of any interest rate changes, company ABC has met its original objective of removing the risk of changing interest rates to a fixed one.
And company XYZ may continue to benefit from the swap contract if interest rates decline to 3%, as company ABC will still pay them a rate of 5%, pocketing them a 2% profit.
Swaps are not limited to interest rate swaps; businesses can also use currency swaps, commodity swaps, and credit default swaps.
Futures Derivatives
Futures derivatives are contracts that allow investors to buy a security or commodity at an agreed price in the future through a central exchange. Investors and businesses usually use futures to speculate for profit or hedge against risk.
For example, company A wants to purchase 10 gold bars from company X in 6 months. The current price of 1 gold bar is 700 USD, and company A is worried that prices may rise in the future. Company A needs a way to eliminate that risk to keep its costs predictable and consistent.
So, company A signs a futures contract with company X that stipulates, in 6 months, they will purchase 10 gold bars for 700 USD per bar. Then in 6 months, company A must settle the agreement, irrespective of whether gold prices go up or down. If gold prices rise to 1,000 USD per bar, company, A still only pays 700 USD as per the agreement. If gold prices drop, the same applies.
In this example, both company A and company X were hedging against price risk. Company X shorted the gold future contract, worrying prices would drop, whilst company A longed the futures contract concerns that prices would rise. A mutually beneficial arrangement to support both businesses.
Alternatively, both companies could also be speculators and just utilise the futures contract as a method to profit from the price changes of gold.
Forward Derivatives
Forward derivatives, also known as forward contracts, are traded over-the-counter, as an agreement between two counterparties to purchase a specific amount of an asset, at a certain price, without a central exchange. Considered riskier than futures, forward derivatives require the buyer and seller parties to agree to their terms and processes for the contract.
The greater risk of forwards over futures comes from the lack of protection if either the buyer or seller cannot live up to their end of the agreement. For example, if one company goes bankrupt, the other party may lose all value on their trade.
Options Derivatives
Options derivatives are agreements that give the buyer a choice as to whether or not they wish to purchase at a specific price (the strike price) at the specified future date. Due to the flexibility and ‘buyer’ side favouritism offered with the Options, it comes with a premium fee. If the price of the options derivative moves in the buyer’s favour, they can exercise the option and benefit from the gains. Conversely, if the option’s price goes against the buyer, they can choose to let the option contract expire and not realise the loss.
Pros and Cons of Derivatives
Derivatives are highly advantageous to eliminate risk but also pose a highly volatile instrument for speculators.
Pros Explained
Helps hedge out risk: A derivative can be used to fix the price of a security or commodity for purchase in the future. Predictable pricing allows businesses to consistently gauge their costs and protect themselves against price fluctuations (volatility).
Can be leveraged: Due to the nature of being a contract derived from the underlying asset, a derivative can be financed by a party, i.e. they can borrow money and purchase more than possible compared to buying the underlying asset.
Helps businesses keep a higher free cash flow with the low margin requirements: Margin trading of derivatives means companies or investors can put a smaller percentage of cash down as collateral, freeing up capital for other business activities. They are allowing businesses to incur a lower capital requirement for an equivalent trade on the underlying asset.
Easier diversification: Derivatives can be settled instantly as contracts through brokers, allow investors or businesses to spread their risk with minimal effort quickly.
Faster execution versus underlying: With the age of online implementation, brokers can settle derivatives in milliseconds. For example, an investor can be exposed to oil investments by buying an online futures contract or going out and physically buying a barrel of oil and storing it. The former is a lot quicker and more cost-effective.
Cons Explained
Easily manipulated by brokers: Brokers who issue derivative contracts are responsible for mirroring the underlying asset price. If the broker has poor liquidity providers (the people with their underlying assets), they may have mispricing and artificial spreads.
Can lose more than the initial investment: Leveraged trading exposes investors to the risk of losing more than they deposit, as they’re borrowing money. For example, if an investor uses 3:1 leverage on an oil derivative, oil prices need only fall by 33% for the investor to lose all of his equity.
A complex product for beginners: Due to the lack of intrinsic value of derivatives (they just mirror the price of underlying assets), prices are volatile and difficult to predict.
Generally incurs additional fees due to leverage: Margin trading comes with additional costs, such as financing fees, spread and commission.
Derivatives vs Securities (Capital Markets)
Derivatives are generally more speculative and offer higher risk than capital market securities due to the availability of leverage and uncertainty of intrinsic value. Derivatives are contracts that mirror the underlying security price, whereas securities traded in capital markets give the investor clear ownership of the underlying asset.
What It Means for Retail Investors
Derivatives are beneficial and volatile tools for any retail trader or investor. They provide various options to mitigate risk, speculate on price movements, and provide diversification that would not be possible without them.
Warning: Derivatives are highly speculative and volatile instruments that may cause investors to lose more than their initial investment.
Retail investors who wish to speculate using derivatives should seek a durable strategy, like the global macro approach, to prevent unnecessary losses and sustain a consistent portfolio.
Article Sources
U.S. Securities and Exchange Commission. “Derivatives, https://www.investor.gov/introduction-investing/investing-basics/glossary/derivatives.” Accessed Jul. 14, 2021.
Commodity Futures Trading Commission. “CFTC Approves Box OFfice Receipt Contracts Submitted by Media Derivatives, https://www.cftc.gov/PressRoom/PressReleases/5834-10.” Accessed Jul. 14, 2021.
Federal Reserve Bank of St. Louis. “Demystifying Derivatives, https://www.stlouisfed.org/publications/regional-economist/october-1994/demystifying-derivatives#endnotes.” Accessed Jul. 13, 2021
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