What Are Derivatives?
Derivatives are financial instruments that derive their value from one or more underlying financial assets. Learn more about the types of derivatives and the pros and cons of investing.
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How Financial Derivatives Work
Financial derivatives are instruments that derive their value from the price of other financial assets, such as stocks, bonds, commodities, currencies, or interest rates.
Examples of financial derivatives include futures, options, swaps, and forwards. Futures and options often trade on an exchange like the Chicago Mercantile Exchange, which is one of the largest derivative markets in the world. Swaps and forwards trade over-the-counter, or OTC.
Important: Investors should keep in mind that prices for derivatives are impacted by the price of the underlying asset. Thus, derivative pricing is, in some manner, indirect. Due to numerous inputs that can impact the fair price of a derivative, financial derivatives can be complex financial instruments. These can potentially involve greater risk of financial loss than the underlying asset.
Derivative Regulations
Financial derivatives in the U.S. are regulated by the Securities and Exchange Commission, or SEC, and the Commodity Futures Trading Commission, or CFTC. The parties involved in financial derivative contracts are regulated by the Financial Industry Regulatory Authority, or FINRA.
Financial derivatives exist in other countries as well, and regulated by a different body (such as the Ontario Securities Commission in Canada).
Derivative Clearinghouse
A derivative clearinghouse is a financial institution that facilitates the exchange of derivatives. The clearinghouse commits each party to a contract and arranges for the settlement of the contract's obligations. Thus, part of the role of the clearinghouse is to decrease counterparty risk.
Derivatives are contracts with stated terms that can include pricing and settlement particulars, the length of the contract, delivery specifications, etc.
Ways Derivatives Are Used
Derivatives can be used for speculative purposes, for risk management purposes, or as a means of accessing unavailable or inaccessible assets or markets. Derivative contracts can exist for a variety of terms.
Derivatives can be used for:
- Hedging: An investor may use derivatives to limit losses. For example, if an investor fears a sudden downturn in a security they are holding, they may buy put options, which can make a profit if the security falls in price, thereby offsetting the loss of the original position.
- Leverage: Derivatives may be used for financial leverage, which can amplify the potential returns of an underlying asset or index.
- Speculation: If an investor believes an asset's price will move significantly in a particular direction, they can attempt to use a derivative strategy to profit from that expected price movement.
- Access to complex assets: Financial derivatives can provide an investor with indirect exposure to assets or markets that may be otherwise be difficult to access.
4 Derivative Investment Types
The four main types of derivatives are futures, options, forwards, and swaps. Common types of underlying assets within these derivative types include stocks, bonds, commodities, bonds, interest rates, currencies, and cryptocurrency.
The four main types of derivatives are:
- Futures
- Options
- Forwards
- Swaps
1. Futures
Futures are financial derivatives that involve a agreed upon contract between parties to exchange an asset at a specific price and on a specific future date. The buyer of the futures contract must buy (and the seller must sell) the specified asset at the price in the contract, regardless of the current market price at the time the contract expires.
For example, a stock market index futures contract would allow investors to increase or reduce exposure to the stock market. The futures contract would specify a particular price at which the parties agree to buy or sell, respectively, a stock index in the future. The most commonly traded stock futures are based on the S&P 500 and Nasdaq 100 indices.
2. Options
Options are a type of derivative contract that involves the right, but not the obligation, to buy or sell the underlying asset. There are two primary types of options; call options and put options.
- A call option gives an investor the right to buy a stock at a specified price up until a certain expiry date.
- A put option gives the investor the right to sell a stock at a specified price up until a certain expiry date.
3. Forwards
Forwards, or forward contracts, are financial derivatives that involve a customized contract between two parties to buy or sell an asset at a specified price on a specified future date. Forward contracts are similar to futures contracts, except that forwards can be customized and do not normally trade on an exchange. Meanwhile, futures contracts tend to be standardized contracts that have an active market on an exchange.
Note: Currency contracts are a common example of a forward contract. Two parties may enter an agreement to trade a specific amount of U.S. Dollars for a different currency, at a specified exchange rate, on a specific date in the future.
4. Swaps
Swaps are financial derivatives that "swap" two sets of cashflows or exposures between two parties for a specified period of time. The cash flows may be determined by an interest rate, currency exchange rates, or the price of a stock or commodity.
One common type of swap is when one party pays a fixed interest rate on a stated notional amount (and receives floating rate payments in return), while the other party pays a floating rate of interest on the same notional (and received a fixed rate in return).
Pros & Cons of Using Derivatives
Derivatives are complex financial instruments that have unique pros and cons. Before considering the use of derivatives, investors are wise to spend a good deal of time leaning about the risks. Derivatives can carry certain advantages and disadvantages, including:
Advantages
- Hedging: Investors may use derivatives to hedge an existing position on an asset they own. Potential profits from the derivative contract may offset losses in the underlying asset.
- Financial leverage: Can be used to amplify returns of an underlying asset, such as a commodity or an index.
- Access to unavailable markets: Derivatives can provide access to assets or markets that may be otherwise be difficult to access for an investor.
Disadvantages
- Complexity: For many investors, derivatives and their strategies can be difficult to understand because they often require advanced investing experience and knowledge to use properly.
- Risk: Derivatives potentially expose investors to losses that can exceed those of the underlying asset.
Bottom Line
Using derivatives, such as futures, options, forward, and swaps can provide investors with unique exposures that would otherwise be difficult to obtain. However, derivatives are also complex and they may carry risks that could be dangerous (such as the risk of writing naked call options). Investors should carefully weigh the benefits and risks before investing in financial derivatives.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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