A derivative is a financial instrument by which certain obligations are attached to the contracting parties, trading on the stock exchange and over-the-counter (OTC). Based on this, each party undertakes to deliver a certain asset in the future. The factor that calculations on this instrument occur in the future makes it possible to guarantee both the supply and sale of a commodity or an asset, and makes this financial mechanism attractive. This term characterizes a type of financial contract, which value depends on an underlying asset. If the underlying asset price fluctuates, then this change is reflected in the derivative.
What is a Derivative
To enter the specific market, traders prefer to use derivatives. The original essence of the derivatives was to provide a fair exchange rates for globally traded goods. There are various kinds of derivatives such as bonds and stocks, futures and option contracts, currencies and commodities, interest rates and market indexes. These instruments may be useful for risk management or speculation, hedging, leveraging a position or other purposes. Having a portfolio is optional for speculation on the price of the underlying asset, because some derivative mechanisms are leveraged.
An important factor affecting the price of a derivative is a change in the price of the financial asset itself, which underlies it, for example, an increase in the price of shares or bonds, a currency price change, an increase in the price of goods, the sale of which is discussed in the derivative. For instance, the market price of oil has a significant impact on the oil futures contract value. Derivative contracts are often traded over-the-counter and can be customized to meet the needs of different partners. In some cases, these derivatives are endowed with counterparty risk, when the default of one of the implicated parties is possible. Since some contracts are unregulated, the trader can buy a currency derivative to fix a certain exchange rate, hedging the risk. The best instruments for hedging are currency futures and currency swaps.
Nowadays, total value of derivatives outstanding estimated at over $600 trillion, derivatives have become more and more popular, this market rapidly grows and offers products, fitting the needs of a particular consumer or risk tolerance. As an example, one of the most popular derivative exchange in the world the Chicago Mercantile Exchange (CME) is famous for trading weather and Bitcoin derivatives.
Types of Derivatives
Futures. It is a contract for the delivery of some primary asset at a certain time in the future, but at a predetermined price. The purpose of concluding a futures contract is to fix a price acceptable to both parties and not depend on its jumps and uncertainty in the market. Traded on an exchange, this contract is considered standardized.
On Oct. 5, 2020, some company decides to buy an oil futures contract with a price of $41.29 per barrel and with expiration date Nov. 18, 2020. The company needs oil in December, and the risk of price increase is quite high. Thus, the futures contract purchase hedges the risk of the company, since the supplier is obliged to deliver oil to the company at the price of $41.29 per barrel at the expiration date. In this case, both parties hedge their risk. Using a long position, this company offsets the risk of the price growth in December. The opposite side is concerned about the risk of falling oil prices, that is why they sell (or short) the fixed price futures contract.
When both parties are speculators, they can terminate their duty to buy or deliver the underlying commodity by closing their contract before the expiration date using an offsetting contract.
The cash-settled futures contract is a standardized contract allows the parties to purchase or sell a certain fundamental financial or tangible instrument at a certain date in the future, at a specified price. All settlement occurs on cash basis. Interest rate futures, stock index futures, volatility futures or weather futures are cash-settled futures contracts.
Forwards. In general, according to the principle of action, the forward contract is similar to the futures. These contracts are customized and more flexible, but not standardized. But these contracts are always over-the-counter traded, that is why they have a high degree of counterparty risk or even default risk, which is connected with a situation, when one of the involved parties is not be able to fulfill their obligations.
Swaps. It is a OTC contract providing for the exchange of certain cash flows at a certain time in the future. Parties can exchange securities, currencies or payments. As an example, a customer can decide to use an interest rate swap to exchange the variable interest rate on a mortgage for payments at a fixed-rate interest. In this way, the risk of unexpected increases in monthly payments would be averted.
A vice versa, in many cases to optimize a company's debt structure, swaps are needed to convert fixed payments into variable rate payments which are linked to market interest rates.
Similarly, a swap can be useful for a company that has issued foreign currency bonds and wants to convert those payments into local currency by entering into a currency swap. Currency swaps may occur because a company receives a loan or foreign currency proceeds that must be converted into local currency.
Options. An options contract is a contract that provides for the option buyer's right to buy or sell the underlying asset within a specified period and at a specified price. It is important that the buyer receives exactly the right, but not the obligation, and it is the main difference between an option and a futures contract. The buyer of an option may refuse to make a deal if, as a result, the conditions turn out to be unfavorable for him. In the case of futures, he does not have this option.
For example, an investor has 1000 stock shares, each worth $500. Although he believes that the value of the asset will increase in the future, he also thinks about potential risks, so he prefers to hedge the risk with an option. The investor buys a put option by which he can sell 1000 shares of the underlying asset at $500 per share, which is considered as the strike price, at the expiration date. For example, the stock price falls to $400 per share by the expiration date and the put option buyer decides to exercise their option and sell the stock for the strike price of $500 per share. If the put option cost the investor $2000 to purchase, then he has only lost the cost of the option because the strike price was equal to the price of the stock when he originally bought the put. This protective put strategy helps to hedge the stock's downside risk.
For instance, an investor doesn't have the stock, currently worth $500 per share, but he believes that its value will rise over the next month. He can buy a call option that gives him the right to buy the stock for $500 before or at the expiration date. Assume this call option cost $2000 and the stock rose to $600 before the expiration date. The buyer can now exercise the option and buy a stock worth $600 per share for the $500 strike price for an initial profit of $100 per share.
Advantages of a Derivative
A derivative is a useful tool for traders and businesses, because it allows them to mitigate risks by locking in prices and hedging against unexpected rate changes.
For example, the producer of agricultural products can protect himself from a fall in the price of his products in the future when he plans to harvest. Or some automobile concern that needs a known amount of non-ferrous metal for production in the future can insure against its rise in price for a certain period. Besides, this company can buy currency forward contract to hedge their currency risk.
To buy the necessary derivative, an investor can borrow cash from a broker, and then he can enter into a derivative contract, what makes this instrument less expensive than others.
A derivative is one of the most profitable instruments for speculative operations. As an example, to purchase a futures contract for 100 000 euros against the US dollar and with delivery in three months requires about $2000. Thus, a trader can get the leverage for a very large amount for free. Unfortunately, at the same time, speculative transactions with derivative securities are the most risky in comparison with other securities.
Disadvantages of a Derivative
The central disadvantages of derivatives are the counterparty risks (connected with a default of one of the party), the unavoidable risks of leverage, and the fact that multiple derivative contracts can lead to system risks.
Derivatives can be extremely complex, so an ordinary investor may not understand all risks connected with this instrument. Since a derivative is usually a leveraged mechanism, it can lead not only to profit increase, but also to an increase in the losses of a particular investor.
A margin trading is another risk. An investor can open positions many times larger than he has in fact, but if the price of the underlying asset falls, then again he will have to close the deal at a loss, and here the leverage is already harmful. In addition to the loss of own funds, this situation may lead to the emergence of large debt obligations.
A derivative is hard to value, because its value comes only from the underlying asset. Besides, some derivatives are sensitive to supply and demand factors and depend on market sentiment.