What’s it: Derivatives are financial instruments whose value is derived from one or more underlying assets. To put it another way, the price depends on the underlying asset. Thus, price fluctuations in the underlying asset ultimately affect the derivative.
The underlying asset can be a physical asset, such as a commodity. Or they are financial assets like stocks and bonds. Currencies and indices are also usually the underlying assets.
Investors buy derivatives for speculative purposes. They profit from price fluctuations without having to buy the underlying asset directly. Some also buy them to hedge investments when prices move against their expectations.
What are some examples of derivatives?
Futures contracts are a derivative example. Forward and swap contracts are other examples. We call them forward commitments, where we settle future transactions in the spot market. However, we agreed on the terms to settle the transaction today. Transactions can take place on an exchange or over-the-counter.
Then, credit default swaps (CDS), options, and asset-backed security (ABS) are other examples. We know them as contingent claims. The underlying asset determines its future payout, subject to some uncertain future event. For example, a credit default swap (CDS) payment is triggered by a credit event, such as a default on an underlying bond.
A forward is a customized derivative contract in which the involved parties agree on a future settlement for an asset whose price is agreed upon when the contract is signed. One party is the seller and is obliged to sell the asset, and the opposite party is the buyer and is obliged to buy the asset. Contract specifications depend on their agreement.
Futures are similar to forward contracts. However, futures contracts are standardized and traded on an exchange. Meanwhile, forward contract trading takes place in the over-the-counter market.
For this reason, futures contracts are more regulated and more transparent. In addition, futures contracts are generally immune to counterparty credit risk, which is the risk when the counterparty does not fulfill its obligations.
A swap is a contract in which each party exchanges a financial instrument or cash flow over a specified period. An example is the plain-vanilla interest rate swap.
Take the simplified case. Your company borrows from the bank and bears floating interest. However, you want fixed interest because it is more predictable. Then, you take a swap contract with the dealer.
Your company makes a fixed interest rate paid to the dealer. The value is based on the national swap principal. As compensation, the dealer will make floating interest payments to you, which you use to fulfill obligations to the bank.
Options contracts give us the right to buy or sell the underlying asset. The price the options contract will be exercised depends on the future price, determined when the contract is entered into. Because it represents a right, not an obligation, it may or may not be exercised.
Credit default swaps (CDS)
Credit default swaps (CDS) work similarly to insurance. For example, we invest in bonds. Then, we buy CDS to protect our investment from the risk of default by paying insurance premiums periodically to the CDS seller.
Asset-backed securities (ABS)
Asset-backed securities (ABS) are fixed-income instruments whose payments come from securitized assets. For example, ABS sellers pool assets such as mortgages, utility bills, receivables, and auto loans. They then package them as fixed-income securities and sell them to investors. And ABS regularly pays from the income stream of the underlying assets.
What assets underlie derivative contracts?
The underlying assets for derivative contracts vary. They may be physical assets. Commodities are common examples, such as gold, silver, natural gas, oil, wheat, and coffee. For example, agriculture and energy commodity contracts are the largest trade, accounting for approximately 36% and 31% of total commodity-based derivative contracts in 2020.
Financial assets such as stocks and bonds can also be the underlying asset. Another example is an index such as the S&P 500 Futures Index, which is traded on the Globex Chicago Mercantile Exchange. Then, the currency is also widely used as the underlying asset for contracts such as futures and forwards.
What is the purpose of buying derivatives?
Derivatives evolved to fulfill two main purposes. First, we buy it for speculative purposes. For example, we buy gold futures contracts to benefit from rising prices without having to buy gold.
Second, derivatives facilitate hedging. For example, we mitigate risk in the underlying by taking contracts whose value moves opposite the underlying position. For example, we hold stock and expect its value to rise long-term. And to protect our investments from adverse price fluctuations, we take futures contracts with short positions. Thus, when the stock price falls, a short position allows us to make a profit, compensating for the loss in the stock investment we hold due to the price drop.
Likewise, when we invest in bonds, we hedge by buying credit default swaps (CDS). So, we can recover our investment when the issuer fails to pay.
Who are the major players in the derivatives market?
Hedgers, speculators, and traders are the main players in the derivatives market. Hedgers hold derivatives to limit the risk due to future price fluctuations. They are usually the ones who own the underlying asset.
Meanwhile, speculators and traders aim at the same. They buy derivative contracts to profit from price fluctuations without buying the underlying asset. They predict which direction the price will move in the future and take positions accordingly. For example, we take a short position in a futures contract if we anticipate a price decline in the future.
Arbitrageurs are another player in the derivatives market. They simultaneously carry out transactions in two or more markets. They buy contracts at a lower price in one market and sell them in another at a higher price.
Where are derivatives traded?
Derivatives trading can take place on exchanges and over-the-counter (OTC) markets. Trading on exchanges involves centralized transactions. Meanwhile, the OTC market takes place informally, where the parties involved are in direct contact to reach an agreement.
What are the contracts traded on the exchange? Futures contracts are an example. The National Stock Exchange of India is listed as the largest derivatives exchange in 2021 by the number of contracts traded, followed by B3 S.A. – Brasil, Bolsa, Balcão, formerly BM&FBOVESPA. Then, there is the CME Group and the Intercontinental Exchange.
Trading on an exchange provides several advantages over over-the-counter. First, contracts are standardized. Second, the market is usually more liquid because it involves many participants. Third, trading is supported by a clearing house for transaction settlement. Fourth, transactions are more transparent because transactions are disclosed to regulatory agencies.
Over-the-counter (OTC) market
Over-the-counter (OTC) markets involve direct deals between the parties involved without a centralized market. Instead, they trade informally to arrange transactions. Forward contracts, for example, are traded in this market.
The over-the-counter market offers several benefits. First, privacy is the biggest advantage. Transactions don’t have to be disclosed to the regulatory body. Thus, the OTC marketplace offers more privacy. Second, the OTC market also offers flexibility. Players can customize contracts according to their needs and look for opposing parties. Third, the OTC market is less regulated. That contrasts with trading on an exchange, which must comply with the rules and policies issued by the regulatory body.
Nonetheless, OTC markets may be less liquid than exchanges – though not always. In addition, since the 2008 crisis, this market has begun to be monitored more closely to make the derivatives market safer and stronger.