Investing has become much more complex over the past decades. In the past, it’s as simple as buying a security that signifies ownership in a corporation and then claiming a part of the firm’s assets and earnings. But today, it is possible to benefit from a firm’s assets and earnings without having to own a share. We call it a “derivative”, a contract between two or more parties based upon a security, its price, risk, and basic term structure.
A derivative a financial instrument whose value derives from and is dependent on the value of an underlying asset. It mirrors the underlying, wherein the fluctuations in the value of that asset influence the value of the derivative itself. The security can take many forms. Aside from stocks and commodities, you can also use derivative instruments on indices, currency or Forex, and interest rates.
Using derivatives isn’t a new concept
If you think about it, the use of derivatives has been around for a quite some time, particularly in the farming industry.
For example, a wheat producer might agree to sell his/her product to a wheat bread manufacturer in 6 months at the current market price of $12 regardless of the future market price. By signing the contract, the two parties locked in the price of wheat, with the producer is seeking to protect himself/herself against the expected decrease in the price of wheat and the manufacturer is seeking to protect him/herself against the expected increase in the price of wheat.
If the price of the commodity falls after 6 months, from $12 to $10, the wheat bread manufacturer loses since he/she could’ve bought the wheat at a cheaper price if he/she had not signed the contract. In this deal, the wheat producer gains $2 profit. Conversely, if the price of the wheat rises, the wheat producer loses since he/she could’ve sold the commodity at a higher price if he/she had not signed the contract. The manufacturer gains profit.
Why Investors Use Derivatives
There are two main uses for derivatives;
- To hedge a risk.
An investor can hedge or mitigate risk in the underlying asset by entering into a derivative contract. Derivative hedgers try to reduce the risk exposure and are not motivated by profit in the derivative market itself; they seek to limit risk by using a derivative instrument (contract) as insurance policies and are indirectly increasing profitability.
- To speculate
Speculating is a technique used by investors when betting on the future price of a security. Derivative speculators, on the other hand, are motivated completely by seeking profit and are willing to take big risks for massive returns. With derivatives that offer investors the opportunity to leverage their positions, they can execute large speculative plays at a low cost.
Four Main Types of Derivatives
Four of the most common examples of derivative instruments are Forwards, Futures, Options, and Swaps.
A forward (or forward contract) is a customized, non-standardized contract between two parties to buy and sell a security at a specified time at a specified future date at a price agreed upon today. Forwards are not traded on a central exchange, thus are not standardized to regulate. That said, they are helpful for hedging a risk.
Forwards and futures are quite similar but unlike the former, futures are regulated and standardized. A future is a standardized contract between two parties to buy or sell a specific asset of standardized quality and quantity for a price agreed today (called the “future price”) with payment and delivery occurring at a determined future date (called the “delivery date”). They are traded on a futures exchange, which performs as an intermediary between buyers and sellers. Futures are often used for speculating commodities.
An options contract is an agreement that gives the “right” but not the “obligation” to buy or sell a security or other financial asset at a specified strike price on or before a specified date. If the buyer or owner exercises his/her “option”, the seller has the obligation to fulfill the transaction (to sell or buy). The buyer should pay the seller a premium for this right.
There are two forms of options; The “call” and the “put”. The call option refers to the owner’s right to buy something at a certain price while the put option refers to the owner’s right to sell something at a certain price. While both are commonly traded, the call option is more frequently discussed.
Two counterparties can swap cash flows of one party’s financial instrument for those of the other party’s financial instrument. It is called the “swaps contract”. The benefits from the exchange of one security to another may depend on various factors, including the type of financial instruments involved.
Author Bio: Sophie Harris is one of the resident writers for FP Markets, a CFD and Forex Trading provider in Australia with over 12 years industry experience serving global clients. Writing informative content about business and finance is her cup of tea.