What are financial derivatives?
Derivative definition: Financial derivatives are contracts that ‘derive’ their value from the market performance of an underlying asset. Instead of the actual asset being exchanged, agreements are made that involve the exchange of cash or other assets for the underlying asset within a certain specified timeframe.
These underlying assets can take various forms including bonds, stocks, currencies, commodities, indexes, and interest rates. Those investing in derivatives do not actually own the underlying entity and the investor is essentially making a bet regarding the direction of price movement, via an agreement with a third party.
Financial derivatives can take various forms such as futures contracts, option contracts, swaps, Contracts for Difference (CFDs), warrants or forward contracts and they can be used for a variety of purposes, most notable hedging and speculation.
Where have you heard about derivatives?
Despite being generally considered to be a modern trading tool, financial derivatives have, in their essence, been around for a very long time indeed. The term itself, however, is something that came about in the 1970s and derivatives have been a semi-regular feature on the news and in financial pages since the 1980s, sometimes with a lot of negative press. You’ll have almost certainly heard the term in the wake of the 2008 global economic downturn when these financial instruments were often accused as being one of main the causes of the crisis.
You’ll have probably heard the term derivatives used in conjunction with risk hedging. Futures contracts, CFDs, options contracts and so on are all superb ways of mitigating losses that can occur as a result of downturns in the market or an asset’s price. Working in a similar way to an insurance policy, derivatives are a valuable part of many investor’s portfolios.
What you need to know about derivatives…
History of derivatives
One of the earliest examples of what we would today consider financial derivatives was in ancient Greece and involved the philosopher Thales, a student of Aristotle. Thales, who was an adept meteorologist, made a prediction based on his observations that there would be a bumper olive crop that year. He was so confident in his observations that he decided to purchase many of the olive farms in the area surrounding Athens before that year’s harvest. It transpired that Thales’ prediction was correct. That year’s weather conditions gave way to a bumper crop of olives and it made him a lot of money in a very early version of what we’d now call a forward contract.
In the 19th century, US farmers were having problems finding buyers for their commodities. To solve the issue, a joint market was set up in 1848 called the Chicago Board of Trade (CBOT). It soon evolved into the world’s first derivatives market whereby instead of buyers and sellers negotiating their own bespoke contracts between themselves, standardised contracts, which anyone could buy and sell, were introduced and listed on the Board’s exchange. In 2007, the CBOT merged with the Chicago Mercantile Exchange to become the CME group and it is still one of the world’s foremost derivatives markets.
Today there is pretty much a financial derivative for everything and many modern financial market innovations are based around the ideas of derivatives. What began as a simple idea in the long distant past were developed into standardised contracts and have now become a labyrinth of complex contracts and financial instruments. There are derivatives for commodities, stocks, real estate and indices. There are even derivatives based on other derivatives. The reason for this is that derivatives are very good at meeting the needs of many different businesses and individuals worldwide.
Types of derivatives
The most common forms of financial derivatives are:
- Futures contracts: This is an agreement made between two parties (a buyer and seller) that a commodity or financial instrument will be bought or sold at a predetermined price on an agreed future date. Futures contracts are standardised which makes for easy trading on organised exchanges known as futures market. These contracts are widely available for dozens of stock market indices and just about every commodity that is commercially produced including industrial and precious metals, seeds, grains, livestock, oil and gas and even carbon credits.
- Forward contracts: These are very similar to futures contracts but with some important differences. A forward contract is tailor-made between two parties and is an agreement to buy or sell an asset or commodity at a given price on a given date. The main differences between forwards and futures is that forward contracts are non-standardised, and they are traded over-the-counter, not on a formal organised market.
- Option contracts: An option contract gives the contract owner (the buyer) the right to buy or sell a pre-determined quantity of an underlying asset. The key here is that the owner has the right to buy, not the obligation. They have grown rapidly in popularity in recent years and options exist for a wide range of underlying assets. The two basic option contract types are ‘call options’ and ‘put options’. With a call option, the owner has the right to buy the underlying asset. With a put option, the owner has the right to sell it.
- Swaps: While not technically derivatives, swaps are usually considered as such. A swap is a contract whereby two parties literally exchange, or swap, a financial instrument’s cash flow for a limited period of time. The benefit of doing so varies greatly and largely depends on the nature of the financial instrument being swapped. Unlike futures and options contracts, swaps are traded over-the-counter between the parties involved and the swaps market is dominated by financial institutions and corporations with few private individuals participating.
- Credit derivatives: This refers to one of many financial instruments and techniques used to separate and transfer credit risk. The risk in question is usually that of a default by corporate or private borrowers. The risk will be transferred to a third party other than the lender or borrower. Although there are many kinds of credit derivative, they can be broadly divided into two categories: funded credit derivatives and unfunded credit derivatives. An unfunded credit derivative is a bilateral agreement between two parties and each party is responsible for completing its payments. A funded credit derivative is where the protection seller (the party who is assuming the credit risk) makes a payment that is later used to settle any credit events that may occur.
- Contracts for Difference (CFDs): A CFD is a contract between a buyer and a seller which stipulates that the buyer will be paid any difference between the current price of an asset and the price at the time of the contracts signing by the seller. In the case of a negative difference occurring, the seller is paid by the buyer.
Uses of derivatives
The most common reasons to use financial derivatives in your trading strategies:
- Hedging or mitigating risk. This is commonly done to insure or protect against the risk of an underlying asset. For example, those wanting to protect themselves in the event of their stock’s price tumbling may buy a put option. Doing this means that whether the stock prices rises or falls, the owner gains because any potential loss is hedged.
- To provide leverage. A small movement in the price of an underlying asset can create a large difference in a derivative’s value. Options contracts in particular are especially valuable in a volatile marketplace. When the underlying asset’s price moves significantly in a more favourable direction then the option’s value is magnified.
- Speculation. This is a technique whereby investors literally speculate on an asset’s future price. This is tied in with leverage because when investors are able to use leverage on their position (as a result of options contracts), they are also able to make large speculative plays at a relatively low cost.
Limitations of using derivatives
Derivatives are often criticised for the following reasons:
- The use of leverage, a common occurrence in the derivatives market, can sometimes result in huge losses. Although they can allow investors to make large amounts of money from small price movements in the underlying asset, there is also the possibility that large losses could be made if the price moves significantly in the other direction. There have been some high-profile examples of this in the past involving AIG, Barings Bank, Société Générale and others.
- Counterparty risk can sometimes be a consequence of some financial derivatives, especially swaps. This is risk that arises from the other party in financial transactions. Different derivatives have different levels of counterparty risk and some of the standardised versions are required by law to have an amount deposited with the exchange in order to pay for any losses.
- Large notional value. Famed American investor Warren Buffett once described derivatives as ‘financial weapons of mass destruction’ because of the danger that their use could create enormous losses for which investors would be unable to compensate. This could then in turn lead to a chain reaction which resulted in a financial crisis.
- Derivatives have also been criticised for their complexity. The various derivative strategies are so complicated that they can only be implemented by experts making them a difficult tool for layman to utilise.
Find out more about derivatives
MoneyWeek has an excellent investment tutorial on derivates and how you can use them to your advantage. See it here.