Originally, derivatives were used to maintain the balance between the exchange rates for products traded globally. With differing values of currencies, global traders needed a system to account for those differences. Today, derivatives are based on a wide variety of transactions and have many more uses.
What Are Derivatives?
Derivatives are agreements between two parties to buy or sell an underlying entity with the value derived from how this entity is performing. The entity (asset) can belong to bonds, commodities, currencies, interest rates, market indices, and stocks.
There are two ways of trading derivatives: over the counter (OTC) and on an exchange. OTC derivatives are more popular and have a greater counterparty risk than the exchange-traded derivatives, which are standardized by clearing houses and thus more strictly regulated.
When to Use Derivatives
Derivatives are typically used for the following purposes:
- Reduction of risks pertaining to the underlying asset (hedging) in case the value of the derivative contract moves in the opposite direction to the underlying position.
- Speculating and making a profit if the value of the underlying asset moves in a given direction, stays in or out of a specified range, and reaches a specific level.
- Leveraging in a way that a small movement in the underlying entity value can result in a large difference in the derivative value.
- Simultaneously entering into transactions into two or more markets for arbitraging purposes.
- Switching the allocations of assets between different classes without influencing the underlying assets.
Common Types of Derivatives
A futures contract is an agreement between two parties for the purchase and delivery of an asset at an agreed price on a future date, even if the asset price changes before this date. Futures are exchange-traded, standardized contracts. They are drawn by clearinghouses that operate an exchange where the contract can be traded.
Traders use futures to mitigate risks or speculate on the price of an underlying entity. For example, a company can enter into a futures contract with another company for a commodity such as oil at a specific price. If this price goes up until the delivery date, then, if the original buyer no longer needs the oil, they can sell the contract to one more company and thus benefit from the price difference (speculate). This example shows that not all futures contracts are settled at the expiration date with the delivery of the underlying entity.
The working principle of a forward contract is similar to that of a futures contract. However, unlike futures, forwards are over the counter products. Besides, they are not exchange-traded and not standardized, being drawn by the parties themselves and not by clearing houses. As a result, they carry a greater counterparty risk – a credit risk in that the buyer or seller may not be able to fulfill the contract obligations. After the creation, the parties in a forward contract can offset their position with other counterparties. This can increase the probability of counterparty risks as more traders become involved in the same contract.
Options are also similar to futures contracts. As with futures, it is possible to use for hedging or speculation on the price of the underlying asset. The difference is that the contract owner has the right, but not the obligation, to buy or sell the asset at a specified date for an agreed price. If the owner exercises this right, the counterparty is obliged to carry out the transaction.
Swaps are contracts to exchange cash flows at or before a certain date in the future. In general, there are two types of swaps: interest rate swaps and currency swaps.
- Interest rate swaps involve the exchange of interest pertaining to cash flows in the same currency between two parties. For example, there can be a swap from a variable interest rate loan to a fixed interest rate loan, and vice versa. Company A has borrowed $1,000,000 and pays a variable rate of 7%. Company B wants to exchange the payments owed on the variable rate loan for the payments owed on a fixed rate loan of 8%. If Company A creates a swap with Company B, it means that Company A will pay 8% to Company B on the sum of $1,000,000. In its turn, Company B will pay Company A 7% interest on the same sum. When the swap begins, Company A will pay Company B only the 1% difference between the rates. If the interest rates go down in a way that the variable rate on the original loan is now 6%, Company A will have to pay Company B the 2% difference. If the rates rise to 9%, Company B will have to pay Company A the 1% difference. No matter how the interest rates change, the swap has achieved the initial purpose of Company A - to turn a variable rate loan into a fixed rate loan.
- Currency swaps involve exchanging the principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. For example, Party A receives 10 million British pounds (GBP), while Party B receives 14 million US dollars (USD). This involves a GBP/USD exchange rate of 1.4. At the end of the agreement, they will swap again by using the same exchange rate and close the deal.
Risks of Derivatives
Despite being a useful tool for investors due to the ability to lock prices and hedge risks, derivatives are also risky because of the following:
- It is difficult to value derivatives because they are based on the price of another asset.
- Most derivatives are sensitive to changes in the amount of time to expiration, the cost of holding the underlying asset, and interest rates.
- OTC derivatives include unpredictable counterparty risks.
Derivatives are agreements between two parties to buy or sell an underlying entity with the value derived from the performance of this entity. Derivatives are most typically used for risk mitigation and price speculation. The most common types of derivatives are futures contracts, forward contracts, options, and swaps. Despite a range of advantages, derivatives can be risky because of valuation difficulties, sensitivity to changes, and counterparty risks.