What are derivatives?
Derivatives are financial instruments that derive their price from an underlying asset. The most common types of derivatives are futures, forwards, options, and swaps. A derivative is a contract between a seller(s) and buyer(s), where the price and value of the contract depends on the price and price movements of the underlying asset. The most common types of underlying are shares, indices, commodities, interest rates, currencies and bonds. Derivatives are commonly used for hedging purposes. Hedging is a form of reducing or eliminating the risk of adverse price movements, which can be regarded a form of insurance.
Standardised derivative contacts can be traded on derivative exchanges (such as Eurex in Europe and CME in the US) and are mostly traded by sophisticated investors. Derivatives are often leveraged instruments, meaning that the exposure generated by entering into a contract is multiple times higher than the initial investment. This means both potential profits and losses are magnified, making it a riskier investment than an investment in shares.
What do Derivatives Mean for the Markets?
Exchange-traded derivatives as they exist today were formalised in the 18th/19th century with the establishment of the Dojima Rice Exchange in Japan and the Chicago Board of Trade (now known as CME). However, derivatives have been around for centuries in their core function hedging against price risk. The first derivative contracts were forward contracts which were created to allow commodity producers / manufacturers to lock-in prices for future sales. Imagine a farmer is looking to sell his harvest in 6 months from now, but he needs a certain minimum price to sustain his business. He enters into a forward agreement with a food producer who commits to buying the harvest in 6 months at the predetermined price.
A second purpose of derivatives is to take a position on directional movements or to exploit arbitrage (price difference) opportunities. Derivatives are, because of the leverage, often a cheaper way to get exposure to markets and allow access to certain markets that would otherwise not be accessible
- Options: An investor has a large position in Royal Dutch Shell shares but wants to limit the downside risk in case the share price drops. He/she could hedge the position by buying put options, giving him/her the right to sell the number shares specified in the contract at a fixed price which limits the potential loss.
- Futures: An investor wants to take a position to benefit from an upward movement in corn price as he/she believes that due to bad weather conditions the harvest will be less productive than in other years and the corn price will increase as a result. Unless the investor has a large enough storage to keep the corn until prices haven risen, he/she can buy a corn future on the derivatives exchange to get exposure to corn prices without needing to own the corn itself.
- Interest rate swap: two parties exchange one kind of cash flow for another. For example, Company A has a variable rate loan, but fears that interest rate will increase making the interest payment more expensive. Therefore, it enters into a interest rate swap with Company B that has a fixed rate loan but an opposing opinion and believes that it would have been better off with a variable rate loan. The two parties essentially swap their interest payment and have turned a variable rate loan into a fixed rate loan and vice versa.