Brief Overview: A derivative is a security whose price is dependant on or derived from one or more underlying assets. The derivative itself is just a contract between two or more parties that’s value is determined on the fluctuations of the underlying assets. The most common assets include; stocks, interest rates, bonds, currencies, commodities and market indexes.
Full Overview: When you hear someone talking about oil futures, currency swaps, stock options, or CFDs, they are all referring to derivative contracts. Derivatives are special financial securities with numerous benefits: They’re used for hedging purposes, speculation, or portfolio diversification, to name a few.
That said, there are also certain risks involved for traders and investors, such as the risk of the counterparty defaulting or high losses due to the excessive usage of leverage.
Here, we’ll take a closer look at the enormous market of derivative contracts, cover their pros and cons, and explain the main types of derivatives.
In finance, derivative contracts are financial securities whose value is dependent on an underlying asset or group of assets, such as stocks, stock indices, currencies, commodities, or interest rates.
Derivative contracts don’t have a value on their own, but their value is derived from the price of the underlying asset that they’re based on.
Derivative contracts can be traded on an exchange or over-the-counter (OTC). It’s important to note that the majority of derivative contracts are traded on the OTC market, which also involves a greater counterparty risk as the OTC market is mostly unregulated. Counterparty risk is the risk that one of the parties of the contract might default.
Since derivative contracts are dependent on the value of the underlying asset, they are often used to speculate on future price movements of an asset, to hedge against negative price fluctuations, or to leverage one’s position in the market.
Initially, derivative contracts were used in the currency markets to account for exchange rate fluctuations, but nowadays derivatives can track almost any asset class. For example, a Japanese investor looking to invest in the eurozone might purchase a derivative contract to hedge against exchange rate risks.
Futures and currency swaps include some popular derivatives, as they can be used to lock in the future exchange rate of a currency pair. By buying a futures contract on the EUR/JPY pair, the Japanese investor could lock in the exchange rate between the Japanese yen and the euro and avoid the negative effects a strengthening yen, which could reduce the potential profits of his euro-based investments.
Similarly, if the Japanese investor believes that the yen could become stronger in the future, he or she could use a derivative contract that follows the price of the yen and profit from the higher exchange rates. Futures and options are popular derivatives used for those purposes.
Pros and Cons of Derivatives
Derivative contracts offer many advantages to investors and traders who want to hedge their risks, speculate on future price movements, or lock in future prices for certain assets. Derivatives can often be purchased for a limited cost, offering an attractive reward-to-risk ratio for market participants.
In addition, they can be traded on leverage, increasing market exposure, and boosting potential profits. However, bear in mind that trading on leverage also magnifies your potential losses. The downside of derivatives is that it’s quite complicated to determine their value because their value derives from the underlying asset.
Also, the price of a derivative depends on its time to expiration, the cost of holding the underlying asset, and interest rates. Derivatives that are traded over-the-counter also include counterparty risk, i.e. the danger that one of the parties might default and be unable to fulfil the contract obligations.
Another disadvantage of derivative contracts is that their liquidity can change regardless of how the underlying asset performs. Those changes in liquidity may, in turn, impact the price of derivatives on the market.
Advantages of derivatives:
- Hedging exchange rate and other risks
- Increasing market exposure through leverage
- Locking in future prices
Disadvantages of derivatives:
- Complicated to determine the exact value
- Counterparty risk
Types of Derivative Contracts
Derivatives can be standardized and traded through a regulated exchange, or non-standardized and traded on the over-the-counter (OTC) market. Common types of derivatives include futures, forwards, swaps, options, and CFDs.
Futures are popular derivative contracts that are an agreement to buy or sell a particular asset at a predetermined price and at a specified time in the future. While futures contracts can cover any asset class, the most commonly used types are futures on commodities, such as oil.
Futures are standardised for quantity and quality and are traded on regulated exchanges, such as the Chicago Mercantile Exchange or New York Mercantile Exchange.
A crude oil futures, for example, includes 1.000 US barrels of oil, and a gold futures includes 100 fine troy ounces of gold.
Futures contracts create an obligation for buyers to buy the underlying asset at the specified price and at a predetermined date, and for sellers to sell and deliver the underlying asset on the same terms.
That’s why traders who look for directional movements sell their futures contracts before their expiration date to avoid taking delivery of the underlying asset.
Unlike futures, forward contracts are non-standardised that trade on the over-the-counter market. Forwards function much like futures, with the key difference that the parties involved in a forward contract can customise the terms of the contract to suit their needs.
Just like futures, forward contracts form an obligation for the buyer to buy and for the seller to sell and deliver the underlying asset at the contract’s terms. Forward contracts are often used for hedging purposes as they transfer the risk between the parties. Since they’re traded OTC, forwards can have counterparty risk.
Swaps are popular derivative contracts used by businesses and financial institutions. Through swaps, two parties exchange the liabilities or cash flow from two different financial instruments.
Each cash flow forms one “leg” of a swap contract, where one leg is fixed and the other variable and based on a floating benchmark rate, such as a currency exchange rate.
Popular swaps include interest rate swaps and currency swaps that can effectively reduce various risks for the involved parties. Swaps are used to stabilise cash flows, assets, and liabilities among financial institutions and businesses, and are usually not traded by retail investors.
Options are derivatives that give the holder the ability, but not an obligation, to buy or sell the underlying asset and a specified price on or before the expiration date.
Options are mostly standardised and trade on regulated exchanges, although you may find some exotic options that trade over-the-counter. They’re a huge market used for hedging and speculating purposes.
For example, a trader could buy a call option on the stocks of Amazon, allowing him to buy the stocks at the price specified in the contract. If the spot price of the stocks increases, the trader would make a profit by executing his right to buy the stocks at a lower price.
However, if the spot price falls, the trader doesn’t have an obligation to buy the stocks at the specified price and can just let the option expire.
Contracts for Difference, or CFDs, are popular derivative contracts among retail traders. Similar to futures, CFDs involve two parties where the selling party agrees to pay the difference in the price of an underlying asset when the buyer decides to close the contracts.
If the price of the underlying contract goes up, the buyer makes a profit, and vice-versa. Since CFDs offer a range of advantages, trading on CFDs is a common way for retail traders to access global markets.
CFDs allow traders to trade to margin, opening a much larger position size than their initial trading account would allow. It’s not unusual for brokers to offer leverage ratios of 50:1, 100:1, or even higher on CFDs. However, trading on leverage involves significant risks as not only your profits get magnified, but also your losses.
Short-selling allows traders to profit from falling prices in the market.
Today, you can find CFDs on all major markets, including currencies, stocks, stock indices, commodities, metals, bonds, interest rates, and so on.
Derivative contracts are financial securities that derive their value from an underlying asset, such as a currency or stock, for example. Although derivatives offer many benefits for market participants, including the ability to hedge, speculate on directional movements, and diversify one’s portfolio, there are also certain risks involved.
When trading non-standardized derivatives on the over-the-counter market, there’s a counterparty risk that refers to the danger that the other party may default, becoming unable to fulfill the contract obligations.
Popular types of derivatives include futures, forwards, swaps, options, and CFDs. Some of them, like futures and options, can be traded through regulated exchanges which reduces counterparty risks, while forwards, swaps and CFDs are mostly traded over-the-counter.
If you decide to trade on any of those derivatives, make sure to get acquainted with all characteristics of the contract before placing a trade.