What are derivatives and how do they work?
What if you want to benefit from a rally in gold but can’t afford to buy and store it? That’s where derivatives come in – financial contracts that give you the opportunity to profit from price movements without owning the asset itself. Let’s break down what the derivative market is and the different types that you can trade.
What is a derivative?
A derivative is a financial contract related to an asset or simply its price. The contract itself has no inherent value. Its value comes from the underlying asset. The word ‘derivative’ means it ‘derives’ its value. The underlying asset can be anything – stock, bond, currency pair or commodity. The worth of the contract is tied to the performance of the asset.
The derivatives market came into being because companies and large institutions needed contracts to hedge risks tied to their purchases of commodities or currency reserves.
Types of derivatives
The notional value of global derivative contracts is estimated to exceed $1 quadrillion — many times global GDP — reflecting the scale of outstanding positions rather than the money actually changing hands. This is because there are several types of derivatives. Each one works differently. Here are some of the most common types.
CFDs (contracts for difference) - agreement between a trader and a broker
The trader agrees to pay the difference in the asset's price. This is from the time the contract opens to the time it closes. You never own the asset. You are just speculating on its price movement. For example, you think a company's stock will rise. You buy a CFD on that stock. The stock price goes up. You close your contract. The broker pays you the difference. The stock price goes down. You must pay the broker the difference.
Futures contracts - agreement to buy or sell an asset in the future
Here, 2 parties agree to trade an asset on a specific price on a specific date in the future. The buyer must buy the asset, and seller must sell the asset at the agreed price, regardless of the market price on that future date.
Imagine a farmer who grows wheat. He is worried about the price of wheat falling. He enters into a futures contract in which he agrees to sell his wheat in 3 months. The price is fixed now. A baker who needs wheat may be worried about the price rising. He buys the same futures contract. He is now guaranteed a fixed price. In 3 months, the farmer sells the wheat to the baker. The price is what they agreed on. This happens even if the market price is higher or lower.
Options contracts - similar to a futures contract but do not include the obligation
An options contract gives the buyer the right, but not the obligation, to buy or sell an asset. The price and date are fixed.
Let's use the same farmer and baker example. The farmer sells an ‘option.’ This option gives the baker the right to buy the wheat at the agreed price. If wheat prices fall, the baker can let the option expire. He can buy the wheat at the lower price in the market. If wheat prices rise, he can exercise his option. He can buy the wheat at the cheaper, fixed price. The farmer gets to keep the small fee the baker paid for the option. This fee is called a premium.
Swaps - agreement to exchange cash flows
These cash flows are based on a specific underlying asset. The most common type is an interest rate swap.
Let’s say, 2 companies have different types of loans. The first has a variable rate loan. The other has a fixed rate loan. They can agree to swap their interest payments. This helps them manage their risks, as the first company might prefer a fixed rate and the other a variable rate. The swap allows them to achieve their desired structure.
Forwards – a customised futures contract
This is a private agreement to buy or sell an asset at a future date. The price is agreed upon on the day the contract is purchased.
A forward contract is more flexible. It can be tailored to the needs of the parties. The downside is it carries more risk. This is because there is no exchange to guarantee the transaction. This is called counterparty risk.
How derivative markets operate
Derivative markets are a huge part of the global financial system.
Key players in the market
The key players include investors, companies, and banks. They all have different reasons for using derivatives. Investors and traders use them to speculate. Companies use them to hedge risks. For instance, a company might hedge against rising raw material costs. Banks not only use them to hedge risks, but they also create and sell them to clients to earn the associated fee.
Where derivatives are traded
Some derivatives are traded on exchanges. These are like stock markets. Examples of derivatives include futures and some options. The exchange provides standardisation and reduces risk. The exchange acts as a middleman and guarantees the transaction.
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Other derivatives are traded over the counter (OTC). This means they are private agreements. They are made directly between 2 parties. Forwards and swaps are often OTC. OTC markets are more flexible, but they also have higher risk. There is no central exchange to guarantee the trade.
Role of leverage in derivative trading
Leverage is a powerful feature of derivatives. It allows you to control a large amount of an asset. But you only use a small amount of your own money. For example, a 10:1 leverage means you can trade $10,000 worth of an asset with only $1,000 of your own funds.
Leverage can increase your profits. But it can also magnify your losses. If the price moves against you, you can lose more than your initial investment. This makes derivative trading very risky. You must be careful and understand the risks involved.
Commodity vs derivative markets
Commodities are raw materials. They include assets like oil, gold, and wheat. Derivatives are financial contracts. Their value is based on these commodities.
Commodities vs derivatives: main differences
A commodity is a physical good. You can touch it and own it. A derivative is a contract. It is a piece of paper or a digital agreement. It represents a claim on the commodity. You do not own the physical commodity itself.
How derivatives help manage commodity price risks
This is a key function of derivatives. Companies use them to manage price volatility. Think about the wheat farmer again. The price of wheat can change a lot. This makes it hard for the farmer to plan. He can use a futures contract to lock in a price for his wheat. He is no longer worried about the price falling. The futures contract helps him manage his risk.
Case study of the derivatives market
Let's look at an airline that needs a lot of jet fuel. The price of oil can be very volatile. A sudden rise in oil prices would hurt the airline's profits. The airline can use a futures contract to buy oil and lock in the price for the future. If the price of oil goes up, the airline is protected. It just needs to pay the lower price mentioned in the contract. The airline has successfully used a derivative to hedge its risk.
Derivatives are important tools as they help companies manage risk. They also allow traders and investors to speculate on asset prices with greater convenience.