What is a Derivative?
What is a Derivative? In finance, a derivative is a financial contract whose value depends on or derives from, the value of an underlying asset or group of assets. The underlying assets include stocks, bonds, commodities, currencies, or other financial instruments.
Derivatives can be used for various purposes, including hedging against risk, speculating on market movements, and creating synthetic exposure to certain assets or markets. Various types of derivatives include options, futures, swaps, and forwards.
Types of Derivatives
There are several types of derivatives and they are:
Options
Options give the owner the right, but not the obligation, to buy or sell an underlying asset at a certain price (strike price) within a specified time period. There are two main types of options: call options and put options.
Futures
Futures contracts are agreements between two parties to buy or sell an underlying asset at a specific price and date in the future. Futures contracts are commonly used for commodities, currencies, and stock indexes.
Forwards
Forwards are similar to futures contracts, but they are customized contracts between two parties to buy or sell an underlying asset at a specific price and date in the future. Forwards are often used for over-the-counter (OTC) transactions.
Swaps
Swaps are agreements between two parties to exchange cash flows or assets based on predetermined terms. Common types of swaps include interest rate swaps, currency swaps, and credit default swaps.
CFDs
CFDs (Contracts for Difference) are derivatives that allow traders to speculate on the price movements of an underlying asset without owning the asset itself. CFDs can be used for stocks, indices, currencies, and commodities.
Structured Products
Structured products are complex financial instruments that are created by combining different derivatives with other securities. Structured products can provide customized investment solutions for investors with specific needs.
Examples of How Derivatives Work?
One Example
An investor can buy a call option on a stock, giving them the right to buy the stock at a certain price within a specified time period. If the stock price rises above the strike price of the option, the investor can exercise the option and buy the stock at the lower price, then sell it at the higher market price, making a profit. If the stock price does not rise above the strike price, the investor can let the option expire worthless, limiting their losses to the premium paid for the option.
Second Example
Futures contracts allow investors to buy or sell an underlying asset at a specific price and date in the future. If the market price of the asset rises above the contract price, the investor can sell the asset at the higher market price, making a profit. If the market price falls below the contract price, the investor must still buy the asset at the higher contract price, resulting in a loss.
Third Example
Swaps allow investors to exchange cash flows or assets based on predetermined terms. For example, an interest rate swap involves exchanging fixed-rate and variable-rate payments based on a notional amount of debt.
History of Derivatives
The history of derivatives dates back to ancient times when farmers and merchants used simple forward contracts to manage their risk. However, modern derivatives trading began in the 1970s, when financial institutions began developing more complex financial instruments.
In 1972, the Chicago Board of Trade (CBOT) established the first futures exchange, which allowed investors to trade contracts for the delivery of agricultural commodities at a future date. The success of the CBOT led to the creation of other futures exchanges, such as the Chicago Mercantile Exchange (CME) and the New York Mercantile Exchange (NYMEX).
In the 1980s, financial institutions began developing more complex derivatives, such as options and swaps. In 1982, the first equity options were traded on the Chicago Board Options Exchange (CBOE). In 1985, the first interest rate swap was executed by JP Morgan and the World Bank.
The use of derivatives grew rapidly in the 1990s, as investors sought to manage risk and speculate on market movements. However, the 1990s also saw several high-profile derivatives failures, including the collapse of Barings Bank in 1995 due to unauthorized trading in derivatives by one of its traders.
The 2000s saw further growth in the derivatives markets, with the development of new types of derivatives, such as credit default swaps. However, the 2008 financial crisis highlighted the risks of complex derivatives, as many investors suffered significant losses due to investments in subprime mortgage-backed securities and other complex financial instruments.
Today, the derivatives market is a global, multi-trillion dollar industry, with a wide range of financial instruments available to investors. Derivatives are used by a wide range of participants, including institutional investors, corporations, and governments, to manage risk, speculate on market movements, and gain exposure to specific
Pros and Cons of Derivatives
Derivatives have advantages and disadvantages, which include:
Pros:
Risk Management: Derivatives allow investors to manage risk by hedging against potential losses from price movements in underlying assets.
Price Discovery: Derivatives can provide information on the expected future price movements of underlying assets, which can help investors make better-informed investment decisions.
Liquidity: Derivatives markets are often more liquid than underlying asset markets, which can make it easier for investors to buy and sell positions.
Leverage: Derivatives can provide leverage, allowing investors to control a larger position with a smaller investment.
Customization: Derivatives can be customized to meet the specific needs of investors, allowing them to tailor their exposure to different assets or markets.
Cons:
Complexity: Derivatives can be complex and difficult to understand, which can increase the risk of making incorrect investment decisions.
Risk: Derivatives are inherently risky, and investors may lose their entire investment if they make incorrect predictions about underlying asset prices.
Counterparty Risk: Derivatives contracts require two parties, and there is a risk that one party may default on their obligations.
Volatility: Derivatives can be more volatile than underlying assets, which can increase the risk of losses.
Regulatory Risks: Derivatives markets are subject to regulatory oversight, and changes in regulations can impact the value of derivative contracts.
Derivative contracts can be complex and involve significant risks, including counterparty risk, volatility risk, and regulatory risk. Investors should have a thorough understanding of the underlying asset and the derivative contract before investing. Investors should also do their own research on the type of derivatives they want to use. So it is recommended to seek the advice of a financial professional before engaging in any derivative.
