A derivative is a security with a price that is dependent upon or derived from one or more underlying assets; it is a contract between at least two parties based on the asset or assets. The value is determined by fluctuations in the underlying asset, with the most common types of underlying assets being stocks, bonds, commodities, currencies, interest rates, and market indexes. For example, in cases involving stock options, the underlying asset is identified as the stock itself.
Derivatives can be traded either of two ways: OTC (over-the-counter) or on an exchange. OTC is traded in contexts other than on a formal exchange such as the NYSE. Approximately 95% of derivatives are traded OTC, meaning they are unregulated and generally involve greater risk. This is termed “over-the-counter” because the derivatives are traded via a dealer network and a bank as an intermediary, instead of a centralized exchange. On an exchange, every party is exposed to offers by every other counterparty, but that is not always the case in dealer networks. There is less transparency and less regulation, so unsophisticated investors take on additional risk. An exchange is a marketplace where derivatives are traded and can be a physical location, such as the NYSE or LSE. An exchange provides less risk for investors, as it is a regulated platform that major companies, governments, and other groups sell securities to the public.
Derivatives are generally a risky category to invest in, with many characterized by high leverage, meaning the security is mostly debt instead of equity. Since there are several different kinds of derivatives, they have a variety of functions. For example, certain types of derivatives can be used for hedging, or buying insurance against risk on an asset. Also, they can be used for speculation in betting on the future price of an asset, along with circumventing exchange rate issues when purchasing shares through a foreign exchange.
One of the most common types of derivatives is a futures contract, which is a legal agreement between parties to buy or sell a particular commodity or financial instrument at a predetermined price at a specified time in the future. They are generally made on the trading floor of a futures exchange such as the Chicago Mercantile Exchange (CME) or Intercontinental Exchange (ICE), and each contract depends on the underlying asset, detailing the quality and quantity of the agreement. For example, if I am looking to buy 1,000 barrels of oil in a month, but I want to be certain of the price that I will have to pay, I could negotiate a futures contract with another party who is selling 1,000 barrels of oil. In the contract, we will both decide on a price per barrel that I will pay in exchange for the 1,000 barrels in one month. If the price per barrel rises over the next month, the other party must sell their barrels of oil at the agreed price and I end up saving money. However, if the price per barrel drops over the next month, I must buy the barrels at the agreed price even if it means I am paying more than the market price. Overall, futures contracts are bets between the two parties on how the value of an asset is going to change over a certain time period.
Another common type of derivative is a forward contract, which is similar to futures contracts, except they are traded OTC instead of on an exchange. It is a customized contract between two parties to buy or sell an asset at a specified price on a future date. Unlike a standard futures contract, a forward contract can be customized to any commodity, amount, and delivery date. Since they are traded OTC, it is easier to customize the terms of agreements, but this comes with a higher degree of default risk. Many of the world’s biggest corporations use forward contracts to hedge currency and interest rate risks; however, the details of an agreement are restricted to the buyer and seller, making it difficult to determine how large the market actually is for these contracts.
A swap is a derivative contract through which two parties agree to exchange almost any type of financial instruments. Most swaps involve cash flows based on a principal amount that both parties agree to; one cash flow is fixed, while the other is variable and based on a benchmark interest rate, floating currency exchange rate, or index price. Swaps are not traded on an exchange, but instead are "Over-the-counter, " or OTC contracts. The most common type of swap is an interest rate swap between two parties, in which one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate to either reduce or increase exposure to fluctuations in interest rates or to obtain a marginally lower interest rate than would have been possible without the swap. The types of interest rate swaps are: fixed to floating, floating to fixed, and float-to-float. For fixed to floating, an example is a company that predicts it can obtain a higher cash flow from a floating rate than issuing a bond at a fixed interest rate. It can enter a swap with a bank in which the company receives a fixed rate and pays a floating rate. The swap is structured to match the maturity and cash flow of the fixed rate bond, with the company and bank agreeing on floating rate index, which is usually just LIBOR. The company will then be paid LIBOR by the bank plus or minus the spread from interest rate conditions in the market. For floating to fixed, an example is a company that does not have access to a fixed rate loan, so they borrow at a floating rate and enter into a swap to achieve a fixed rate. An example of a float to float, also known as a basis swap, is if a company enters a swap in order to change the tenor, payment frequency, of the floating rate index. They could swap from three-month to six-month LIBOR, or change to a different index, such as the federal funds rate or Treasury bill rate.
An option is similar to a futures contract in that it is an agreement between two parties granting one the opportunity to buy or sell a security at a predetermined future date. Just like with futures, the option buyers and option writers have differing views regarding the future of an underlying security. Options are used to speculate or reduce the risk of an asset, making them relatively risky. The main difference that separates options from futures is that the buyer or seller is not obligated to make the transaction if they decide not to. The main feature of an option is the strike price, or the price that a derivative can be exercised, usually referring to the price of the underlying asset. There are four types of options: call, put, long, and short. For a call option, the investor has the right, but not obligation, to buy a financial instrument at a specified price within a certain time period. The profit is made on a call option when the price of the underlying asset increases. A put option gives the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specific price within a certain time period. A put option becomes more valuable when the underlying stock depreciates in value. A long position occurs when someone buys a security with the expectation that the asset will rise in value, and they have no plan to sell the security in the near future. A short position is when the investor expects the price of a security to fall, at which point they purchase the shares in the open market and return the shares to the broker they borrowed them from.
There are a few main risks involved in derivatives trading. Possibly the most dangerous is the fact that it is almost impossible to know the true value of any derivative because the price is based on the value of the underlying asset. Another risk is the high amount of leverage, resulting from investors only being required to put 2-10% of the contract into a margin account. If the value keeps dropping, then they must keep adding money to the margin account to maintain ownership. If the price continues to drop massively, enormous losses will ensue from attempting to cover the margin account. With over 95% of derivatives trading occurring OTC, the risk of fraud or default is high, meaning that the derivatives market is dangerous to invest in if one does not know what they are doing.
Options Payoff Graphs:
Futures & Forward Contracts Payoff Graphs: