What Is a Derivative?

Introduction

A derivative is an asset whose price is determined by the movements of an underlying asset or financial instrument. Derivatives have become popular financial instruments mostly among banks, hedge funds, and other investment firms due to their ability to reduce risk, provide market stability, and facilitate hedging. Types of derivatives include forwards, futures, options, swaps, and many more.

Definition of a Derivative

In finance, a derivative is a contract between two parties that derives its value from an underlying asset or a set of underlying assets. Derivatives are used in the financial and commodities markets to manage the risk associated with investing in and trading those markets. They have many different uses—from hedging and arbitrage to speculation and derivatives trading. By using derivatives, traders and investors can better manage their risk exposure in volatile or fast-moving markets.

What It Is

Derivatives are financial instruments derived from an underlying asset or a set of underlying assets. They are based off of the asset's performance and can represent a long or short position in that asset. Derivatives are sometimes referred to as 'options' because these instruments have a set of pre-agreed-upon conditions that must be met before an option's potential payoff is realized—conditions such as an expiration date, the underlying asset’s current performance, the strike price, and the buyer’s underlying stock.

Why It Is Useful

By using derivatives, traders and investors can better manage their risk in fast-moving or volatile markets. More specifically, derivatives help spread risk and protect against potential losses. By speculating on the direction of the market, derivatives can give traders and investors the chance to make profits even when the underlying asset’s price is falling. In addition, derivatives can be combined with other investment strategies, such as trading or arbitrage. Finally, derivatives can be used for hedging purposes, allowing traders and investors to reduce their overall risk exposure.

• Derivatives can help spread risk and protect against potential losses
• They give traders and investors the chance to make profits even when the underlying asset’s price is falling
• Derivatives can be used in combination with other investment strategies like trading or arbitrage
• Derivatives can be used for hedging purposes to reduce overall risk exposure

Types of Derivatives

Derivatives are financial instruments whose value is derived from the underlying asset. Derivatives are used by traders to make money from price changes or the volatility of prices of assets. There are various types of derivatives available to traders, and the main ones include futures, options, and swaps.

Futures

A futures contract is an agreement between two traders to buy or sell an asset at a predetermined price on a later date. The underlying asset can be commodities, stocks, interest rates, indices, currencies, and more. The two parties involved in the agreement are required to abide by the terms of the futures contract, even though it’s not directly traded on any exchange.

Options

Options are financial contracts that give the buyer the right, but not the obligation, to buy or sell the underlying asset at a predetermined price and date. An option buyer pays a premium to the option seller in return for this right. There are two types of options: Call options, which gives the buyer the right to buy the asset, and Put options, which gives the buyer the right to sell the asset.

Swaps

A swap is a type of derivative contract in which two parties exchange the cash flows of one party’s financial instruments for those of the other. Swaps can involve a wide range of assets, including commodities, currencies, and interest rates. The two parties must agree to exchange the cash flows and when these cash flows will take place in the future.

Futures

Futures are a form of derivative that are called a forward contract. These contracts offer the buyer and seller the ability to buy and sell assets at predetermined prices. They are used to speculate on the price of the asset and provide more flexibility for both the buyer and seller.

Definition

Futures contracts, sometimes referred to as forward contracts, are an agreement between two parties in which one party agrees to buy a predetermined amount of a specified asset at an agreed upon price at some point in the future. These contracts are legally binding, and once they are entered, both parties must abide by the predetermined conditions of the contract.

How They Work

Futures contracts are traded on exchanges, and the terms of each contract are standardized. The buyer agrees to buy a fixed quantity at a predetermined price, and the seller agrees to sell the same quantity at that price. Both parties must abide by the terms of the contract, regardless of the changes in the current price of the underlying asset. This way, futures contracts can be used to bet on the future movements of the price of an asset.

Examples

Futures contracts are used in various areas of the financial markets, and they can be applied to commodities, stocks, currencies, and even bonds. Common examples include futures contracts on commodities such as oil and gold, as well as indices and other financial instruments. In addition, futures contracts can be used to trade the stock markets, and are sometimes referred to as stock index futures.

• Oil futures contracts allow you to buy or sell a specified quantity of oil at a predetermined price.
• Gold futures contracts allow you to speculate on the future price of the metal.
• Stock index futures offer the ability to buy or sell a basket of stocks in the future.
• Currency futures allow you to speculate on the movements of foreign exchange rates.

Options

Options are a type of derivative, which is a financial instrument that derives its value from underlying assets such as stocks and bonds. An option is specifically a contract that allows the buyer the right to buy or sell an asset at a stated price within a certain period of time. Depending on the terms of the option contract and the asset involved, there are two main types of options, call options and put options.

Definition

A call option gives the buyer the right, but not the obligation, to buy a predetermined number of shares at a specified price, known as the strike or exercise price, on or before a predetermined date in the future. On the other hand, a put option gives the buyer the right to sell a fixed number of shares at a specified price on or before a predetermined date in the future. In this case, the buyer of an option does not have to exercise his or her option; instead, these options can be traded in the market.

How They Work

If the option buyer wishes to exercise the option, they must contact the seller and pay the exercise price (or, if they are selling the option, they will receive the exercise price). If the option is not exercised, it will expire and the buyer will not be able to benefit from the option contract. If the option is not exercised, the option buyer may also decide to trade the option on a public or private options exchange.

Examples

For example, an investor might purchase a call option on a stock in order to buy stock at a later date, at a lower price than the current market value. If the stock price rises by the time the option expires, the option buyer can exercise the option, buying the stock at the lower exercise price. Conversely, an investor who puts options on the stock will benefit if the stock price drops below the exercise price by the expiration date of the option, allowing the option seller to purchase the stock at a lower price than the current market value.

Options are very versatile instruments, and they can be used to speculate and hedge against potential market moves. Options can also be used to create profitable synthetic positions such as a straddle or a strangle. For instance, if an investor buys a put and a call option on the same underlying asset (or a spread option) with the same strike price and expiration date, the investor has created a strategy known as a straddle, which profits if the underlying asset experiences large price fluctuations.

6. Swaps

Swaps are financial derivatives, which involve exchanging one set of cash flows for another over a predetermined period of time. This can be done between two counterparties, or a counterparty and a financial institution. A swap is a risk management tool or a method of speculative investing.

a. Definition

A swap is, essentially, an agreement between two parties to exchange cash flows or other financial instruments over a set period of time. A common type of swap is a spot rate or forward rate agreement, which involves the exchange of two currencies’ spot rates or forward rates for a specified period of time.

b. How They Work

With a swap, two parties agree to exchange cash flows over a period of time. The two parties will agree to exchange either fixed or floating payments depending on the terms of the contract. The fixed payments are agreed at the time of the agreement while the floating payments change based on predetermined criteria such as interest rates or foreign exchange rates.

c. Examples

There are many types of swaps, including interest rate swaps, currency swaps, and commodity swaps. An interest rate swap is an agreement to exchange cash flows based on a set interest rate. A currency swap is an agreement to exchange two currencies’ spot rates or forward rates for a specified period of time. A commodity swap involves exchanging cash flows based on a commodity, such as crude oil.

• Interest rate swaps
• Currency swaps
• Commodity swaps

Conclusion

Derivatives are financial instruments used as a tool for hedging, speculation, or transferring risk. This can include physical items like commodities and currencies, but also financial instruments like stocks, bonds, and ETFs. The most ubiquitous type of derivative is the futures contract, which establishes a future date and price for purchase of an asset. Options, swaps, and warrants are other popular types of derivative contracts.

The popularity of derivatives lies in their ability to provide exposure to markets without taking on the full risk associated with ownership of the underlying asset. They can also be used to conveniently hedge against risk and/or speculate on potential market movement. With the potential for high returns, derivatives have become an attractive option for many investors.