Derivatives

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Derivative

What Is a Derivative?

A derivative is a financial security with a value that is reliant upon or derived from, an underlying asset or group of assets—a benchmark. The derivative itself is a contract between two or more parties, and the derivative derives its price from fluctuations in the underlying asset.

The most common underlying assets for derivatives are stocks, bonds, commodities, currencies, interest rates, and market indexes. These assets are commonly purchased through brokerages.

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Derivatives can trade over-the-counter (OTC) or on an exchange. OTC derivatives constitute a greater proportion of the derivatives market. OTC-traded derivatives, generally have a greater possibility of counterparty risk. Counterparty risk is the danger that one of the parties involved in the transaction might default. These parties trade between two private parties and are unregulated.

Conversely, derivatives that are exchange-traded are standardized and more heavily regulated.

Derivative: My Favorite Financial Term

The Basics of a Derivative

Derivatives can be used to hedge a position, speculate on the directional movement of an underlying asset, or give leverage to holdings. Their value comes from the fluctuations of the values of the underlying asset.

Originally, derivatives were used to ensure balanced exchange rates for goods traded internationally. With the differing values of national currencies, international traders needed a system to account for differences. Today, derivatives are based upon a wide variety of transactions and have many more uses. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a region.

For example, imagine a European investor, whose investment accounts are all denominated in euros (EUR). This investor purchases shares of a U.S. company through a U.S. exchange using U.S. dollars (USD). Now the investor is exposed to exchange-rate risk while holding that stock. Exchange-rate risk the threat that the value of the euro will increase in relation to the USD. If the value of the euro rises, any profits the investor realizes upon selling the stock become less valuable when they are converted into euros.

To hedge this risk, the investor could purchase a currency derivative to lock in a specific exchange rate. Derivatives that could be used to hedge this kind of risk include currency futures and currency swaps.

A speculator who expects the euro to appreciate compared to the dollar could profit by using a derivative that rises in value with the euro. When using derivatives to speculate on the price movement of an underlying asset, the investor does not need to have a holding or portfolio presence in the underlying asset.

Key Takeaways

  • Derivatives are securities that derive their value from an underlying asset or benchmark.
  • Common derivatives include futures contracts, forwards, options, and swaps.
  • Most derivatives are not traded on exchanges and are used by institutions to hedge risk or speculate on price changes in the underlying asset.
  • Exchange-traded derivatives like futures or stock options are standardized and eliminate or reduce many of the risks of over-the-counter derivatives
  • Derivatives are usually leveraged instruments, which increases their potential risks and rewards.

Common Forms of Derivatives

There are many different types of derivatives that can be used for risk management, for speculation, and to leverage a position. Derivatives is a growing marketplace and offer products to fit nearly any need or risk tolerance.

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Futures

Futures contracts—also known simply as futures—are an agreement between two parties for the purchase and delivery of an asset at an agreed upon price at a future date. Futures trade on an exchange, and the contracts are standardized. Traders will use a futures contract to hedge their risk or speculate on the price of an underlying asset. The parties involved in the futures transaction are obligated to fulfill a commitment to buy or sell the underlying asset.

For example, say that Nov. 6, 2020, Company-A buys a futures contract for oil at a price of $62.22 per barrel that expires Dec. 19, 2020. The company does this because it needs oil in December and is concerned that the price will rise before the company needs to buy. Buying an oil futures contract hedges the company’s risk because the seller on the other side of the contract is obligated to deliver oil to Company-A for $62.22 per barrel once the contract has expired. Assume oil prices rise to $80 per barrel by Dec. 19, 2020. Company-A can accept delivery of the oil from the seller of the futures contract, but if it no longer needs the oil, it can also sell the contract before expiration and keep the profits.

In this example, it is possible that both the futures buyer and seller were hedging risk. Company-A needed oil in the future and wanted to offset the risk that the price may rise in December with a long position in an oil futures contract. The seller could be an oil company that was concerned about falling oil prices and wanted to eliminate that risk by selling or “shorting” a futures contract that fixed the price it would get in December.

It is also possible that the seller or buyer—or both—of the oil futures parties were speculators with the opposite opinion about the direction of December oil. If the parties involved in the futures contract were speculators, it is unlikely that either of them would want to make arrangements for delivery of several barrels of crude oil. Speculators can end their obligation to purchase or deliver the underlying commodity by closing—unwinding—their contract before expiration with an offsetting contract.

For example, the futures contract for West Texas Intermediate (WTI) oil trades on the CME represents 1,000 barrels of oil. If the price of oil rose from $62.22 to $80 per barrel, the trader with the long position—the buyer—in the futures contract would have profited $17,780 [($80 – $62.22) X 1,000 = $17,780]. The trader with the short position—the seller—in the contract would have a loss of $17,780.

Not all futures contracts are settled at expiration by delivering the underlying asset. Many derivatives are cash-settled, which means that the gain or loss in the trade is simply an accounting cash flow to the trader’s brokerage account. Futures contracts that are cash settled include many interest rate futures, stock index futures, and more unusual instruments like volatility futures or weather futures.

Forwards

Forward contracts—known simply as forwards—are similar to futures, but do not trade on an exchange, only over-the-counter. When a forward contract is created, the buyer and seller may have customized the terms, size and settlement process for the derivative. As OTC products, forward contracts carry a greater degree of counterparty risk for both buyers and sellers.

Counterparty risks are a kind of credit risk in that the buyer or seller may not be able to live up to the obligations outlined in the contract. If one party of the contract becomes insolvent, the other party may have no recourse and could lose the value of its position. Once created, the parties in a forward contract can offset their position with other counterparties, which can increase the potential for counterparty risks as more traders become involved in the same contract.

Swaps

Swaps are another common type of derivative, often used to exchange one kind of cash flow with another. For example, a trader might use an interest rate swap to switch from a variable interest rate loan to a fixed interest rate loan, or vice versa.

Imagine that Company XYZ has borrowed $1,000,000 and pays a variable rate of interest on the loan that is currently 6%. XYZ may be concerned about rising interest rates that will increase the costs of this loan or encounter a lender that is reluctant to extend more credit while the company has this variable rate risk.

Assume that XYZ creates a swap with Company QRS, which is willing to exchange the payments owed on the variable rate loan for the payments owed on a fixed rate loan of 7%. That means that XYZ will pay 7% to QRS on its $1,000,000 principal, and QRS will pay XYZ 6% interest on the same principal. At the beginning of the swap, XYZ will just pay QRS the 1% difference between the two swap rates.

If interest rates fall so that the variable rate on the original loan is now 5%, Company XYZ will have to pay Company QRS the 2% difference on the loan. If interest rates rise to 8%, then QRS would have to pay XYZ the 1% difference between the two swap rates. Regardless of how interest rates change, the swap has achieved XYZ’s original objective of turning a variable rate loan into a fixed rate loan.

Swaps can also be constructed to exchange currency exchange rate risk or the risk of default on a loan or cash flows from other business activities. Swaps related to the cash flows and potential defaults of mortgage bonds are an extremely popular kind of derivative—a bit too popular. In the past. It was the counterparty risk of swaps like this that eventually spiraled into the credit crisis of 2008.

Options

An options contract is similar to a futures contract in that it is an agreement between two parties to buy or sell an asset at a predetermined future date for a specific price. The key difference between options and futures is that, with an option, the buyer is not obliged to exercise their agreement to buy or sell. It is an opportunity only, not an obligation—futures are obligations. As with futures, options may be used to hedge or speculate on the price of the underlying asset.

Imagine an investor owns 100 shares of a stock worth $50 per share they believe the stock’s value will rise in the future. However, this investor is concerned about potential risks and decides to hedge their position with an option. The investor could buy a put option that gives them the right to sell 100 shares of the underlying stock for $50 per share—known as the strike price—until a specific day in the future—known as the expiration date.

Assume that the stock falls in value to $40 per share by expiration and the put option buyer decides to exercise their option and sell the stock for the original strike price of $50 per share. If the put option cost the investor $200 to purchase, then they have only lost the cost of the option because the strike price was equal to the price of the stock when they originally bought the put. A strategy like this is called a protective put because it hedges the stock’s downside risk.

Alternatively, assume an investor does not own the stock that is currently worth $50 per share. However, they believe that the stock will rise in value over the next month. This investor could buy a call option that gives them the right to buy the stock for $50 before or at expiration. Assume that this call option cost $200 and the stock rose to $60 before expiration. The call buyer can now exercise their option and buy a stock worth $60 per share for the $50 strike price, which is an initial profit of $10 per share. A call option represents 100 shares, so the real profit is $1,000 less the cost of the option—the premium—and any brokerage commission fees.

In both examples, the put and call option sellers are obligated to fulfill their side of the contract if the call or put option buyer chooses to exercise the contract. However, if a stock’s price is above the strike price at expiration, the put will be worthless and the seller—the option writer—gets to keep the premium as the option expires. If the stock’s price is below the strike price at expiration, the call will be worthless and the call seller will keep the premium. Some options can be exercised before expiration. These are known as American-style options, but their use and early exercise are rare.

Advantages of Derivatives

As the above examples illustrate, derivatives can be a useful tool for businesses and investors alike. They provide a way to lock in prices, hedge against unfavorable movements in rates, and mitigate risks—often for a limited cost. In addition, derivatives can often be purchased on margin—that is, with borrowed funds—which makes them even less expensive.

Downside of Derivatives

On the downside, derivatives are difficult to value because they are based on the price of another asset. The risks for OTC derivatives include counter-party risks that are difficult to predict or value as well. Most derivatives are also sensitive to changes in the amount of time to expiration, the cost of holding the underlying asset, and interest rates. These variables make it difficult to perfectly match the value of a derivative with the underlying asset.

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Definition of derivative

Definition of derivative (Entry 2 of 2)

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These example sentences are selected automatically from various online news sources to reflect current usage of the word ‘derivative.’ Views expressed in the examples do not represent the opinion of Merriam-Webster or its editors. Send us feedback.

First Known Use of derivative

15th century, in the meaning defined at sense 1

circa 1530, in the meaning defined at sense 1

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“Derivative.” Merriam-Webster.com Dictionary, Merriam-Webster, https://www.merriam-webster.com/dictionary/derivative. Accessed 5 Apr. 2020.

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Financial Definition of derivative

A derivative is a financial contract with a value that is derived from an underlying asset. Derivatives have no direct value in and of themselves — their value is based on the expected future price movements of their underlying asset.

Derivatives are often used as an instrument to hedge risk for one party of a contract, while offering the potential for high returns for the other party. Derivatives have been created to mitigate a remarkable number of risks: fluctuations in stock, bond, commodity, and index prices; changes in foreign exchange rates; changes in interest rates; and weather events, to name a few.

One of the most commonly used derivatives is the option. Let’s look at an example:

Say Company XYZ is involved in the production of pre-packaged foods. They are a large consumer of flour and other commodities, which are subject to volatile price movements.

In order for the company to assure any kind of consistency with their product and meet their bottom-line objectives, they need to be able to purchase commodities at a predictable and market-friendly rate. In order to do this, company XYZ would enter into an options contract with farmers or wheat producers to buy a certain amount of their crop at a certain price during an agreed upon period of time. If the price of wheat, for whatever reason, goes above the threshold, then Company XYZ can exercise the option and purchase the asset at the strike price. Company XYZ pays a premium for this privilege, but receives protection in return for one of their most important input costs. If XYZ decides not to exercise its option, the producer is free to sell the asset at market value to any buyer. In the end, the partnership acts as a win-win for both parties: Company XYZ is guaranteed a competitive price for the commodity, while the producer is assured of a fair value for its goods.

In this example, the value of the option is “derived” from an underlying asset; in this case, a certain number of bushels of wheat.

Other common derivatives include futures, forwards and swaps.

As often is the case in trading, the more risk you undertake the more reward you stand to gain. Derivatives can be used on both sides of the equation, to either reduce risk or assume risk with the possibility of a commensurate reward.

This is where derivatives have received such notoriety as of late: in the dark art of speculating through derivatives. Speculators who enter into a derivative contract are essentially betting that the future price of the asset will be substantially different from the expected price held by the other member of the contract. They operate under the assumption that the party seeking insurance has it wrong in regard to the future market price, and look to profit from the error.

Contrary to popular opinion, though, derivatives are not inherently bad. In fact, they are a necessity for many companies to ensure profits in volatile markets or provide mitigated risk for everyday investors looking for investment insurance.

Derivatives, With Their Risks and Rewards

What Are the Risks Versus Rewards?

A derivative is a financial contract that derives its value from an underlying asset. The buyer agrees to purchase the asset on a specific date at a specific price.

Derivatives are often used for commodities, such as oil, gasoline, or gold. Another asset class is currencies, often the U.S. dollar. There are derivatives based on stocks or bonds. Still others use interest rates, such as the yield on the 10-year Treasury note.

The contract’s seller doesn’t have to own the underlying asset. He can fulfill the contract by giving the buyer enough money to buy the asset at the prevailing price. He can also give the buyer another derivative contract that offsets the value of the first. This makes derivatives much easier to trade than the asset itself.

Derivatives Trading

In 2020, 25 billion derivative contracts   were traded. Trading activity in interest rate futures and options increased in North America and Europe thanks to higher interest rates. Trading in Asia declined due to a decrease in commodity futures in China. These contracts were worth around $570 trillion.

Most of the world’s 500 largest companies use derivatives to lower risk. For example, a futures contract promises the delivery of raw materials at an agreed-upon price. This way the company is protected if prices rise. Companies also write contracts to protect themselves from changes in exchange rates and interest rates.

Derivatives make future cash flows more predictable. They allow companies to forecast their earnings more accurately. That predictability boosts stock prices. Businesses then need less cash on hand to cover emergencies. They can reinvest more into their business.

Most derivatives trading is done by hedge funds and other investors to gain more leverage. Derivatives only require a small down payment, called “paying on margin.” Many derivatives contracts are offset, or liquidated, by another derivative before coming to term. These traders don’t worry about having enough money to pay off the derivative if the market goes against them. If they win, they cash in.

Derivatives that are traded between two companies or traders that know each other personally are called “over-the-counter” options. They are also traded through an intermediary, usually a large bank.

Exchanges

A small percentage of the world’s derivatives are traded on exchanges.   These public exchanges set standardized contract terms. They specify the premiums or discounts on the contract price. This standardization improves the liquidity of derivatives. It makes them more or less exchangeable, thus making them more useful for hedging.

Exchanges can also be a clearinghouse, acting as the actual buyer or seller of the derivative. That makes it safer for traders since they know the contract will be fulfilled. In 2020, the Dodd-Frank Wall Street Reform Act was signed in response to the financial crisis and to prevent excessive risk-taking.

The largest exchange is the CME Group.   It’s the merger between the Chicago Board of Trade and the Chicago Mercantile Exchange, also called CME or the Merc. It trades derivatives in all asset classes.

Stock options are traded on the NASDAQ or the Chicago Board Options Exchange. Futures contracts are traded on the Intercontinental Exchange. It acquired the New York Board of Trade in 2007. It focuses on financial contracts, especially on currency, and agricultural contracts, principally dealing with coffee and cotton. The Commodity Futures Trading Commission or the Securities and Exchange Commission regulates these exchanges. Trading Organizations, Clearing Organizations, and SEC Self-Regulating Organizations have a list of exchanges. 

Types of Financial Derivatives

The most notorious derivatives are collateralized debt obligations. CDOs were a primary cause of the 2008 financial crisis. These bundle debt like auto loans, credit card debt, or mortgages into a security. Its value is based on the promised repayment of the loans. There are two major types. Asset-backed commercial paper is based on corporate and business debt. Mortgage-backed securities are based on mortgages. When the housing market collapsed in 2006, so did the value of the MBS and then the ABCP.

The most common type of derivative is a swap. It is an agreement to exchange one asset or debt for a similar one. The purpose is to lower risk for both parties. Most of them are either currency swaps or interest rate swaps. For example, a trader might sell stock in the United States and buy it in a foreign currency to hedge currency risk. These are OTC, so these are not traded on an exchange. A company might swap the fixed-rate coupon stream of a bond for a variable-rate payment stream of another company’s bond.

The most infamous of these swaps were credit default swaps. They also helped cause the 2008 financial crisis. They were sold to insure against the default of municipal bonds, corporate debt, or mortgage-backed securities. When the MBS market collapsed, there wasn’t enough capital to pay off the CDS holders. The federal government had to nationalize the American International Group. Thanks to Dodd-Frank, swaps are now regulated by the CFTC.

Forwards are another OTC derivative.   They are agreements to buy or sell an asset at an agreed-upon price at a specific date in the future. The two parties can customize their forward a lot. Forwards are used to hedge risk in commodities, interest rates, exchange rates, or equities.

Another influential type of derivative is a futures contract. The most widely used are commodities futures. Of these, the most important are oil price futures. They set the price of oil and, ultimately, gasoline.

Another type of derivative simply gives the buyer the option to either buy or sell the asset at a certain price and date.

The most widely used are options. The right to buy is a call option, and the right to sell a stock is a put option.

Four Risks of Derivatives

Derivatives have four large risks. The most dangerous is that it’s almost impossible to know any derivative’s real value. It’s based on the value of one or more underlying assets. Their complexity makes them difficult to price. That’s the reason mortgage-backed securities were so deadly to the economy. No one, not even the computer programmers who created them, knew what their price was when housing prices dropped. Banks had become unwilling to trade them because they couldn’t value them.

Another risk is also one of the things that makes them so attractive: leverage. For example, futures traders are only required to put 2% to 10% of the contract into a margin account to maintain ownership. If the value of the underlying asset drops, they must add money to the margin account to maintain that percentage until the contract expires or is offset. If the commodity price keeps dropping, covering the margin account can lead to enormous losses. The U.S. Commodity Futures Trading Commission Education Center provides a lot of information about derivatives. 

The third risk is their time restriction. It’s one thing to bet that gas prices will go up. It’s another thing entirely to try to predict exactly when that will happen. No one who bought MBS thought housing prices would drop. The last time they did was the Great Depression. They also thought they were protected by CDS. The leverage involved meant that when losses occurred, they were magnified throughout the entire economy. Furthermore, they were unregulated and not sold on exchanges. That’s a risk unique to OTC derivatives. 

Last but not least is the potential for scams.   Bernie Madoff built his Ponzi scheme on derivatives. Fraud is rampant in the derivatives market. The CFTC advisory lists the latest scams in commodities futures. 

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