Derivative

Derivatives are a type of financial product whose value comes from other things, like the changes in prices of stocks, bonds, commodities, currencies, interest rates, or even entire market indexes. They can also be based on other things that affect money matters, like the weather or the cost of shipping.

Most derivatives are traded over the counter (OTC), which means they’re traded in networks of dealers and not on formal stock exchanges. Investors use derivatives for two main reasons: to hedge risk and to speculate. Hedging is like getting an insurance policy to protect against losses. Speculation is about trying to make a profit by predicting future price movements. Derivatives are complicated and require a good understanding of trading.

Futures contracts are agreements where a buyer (taking a long position) and a seller (taking a short position) decide on a price now for something they’ll trade in the future. This ‘something’ can be a physical item like oil, gold, or wheat, or a financial asset like stocks or foreign currencies. They agree on a set price, amount, and a future date when they’ll exchange or settle up for this asset. The value of these contracts changes with the price of the asset they’re based on. Every day, any profits or losses are added or taken away from a trader’s account.

Futures contracts are formal, follow certain rules, and are traded on special exchanges for futures. To start trading, you need to put down a small part (initial margin) of the contract’s total value in your futures trading account. You also have to keep a certain amount in your account (maintenance margin) to handle potential losses. You can settle futures in cash or sell them before they expire by taking an opposite position to the one you initially took.

• Forwards: A forwards contract is like a futures contract. But forwards are not standardized or regulated and are only traded in the over-the-counter (OTC) markets, usually between institutional investors or large organizations. Forwards don’t trade on futures exchanges by retail investors. Unlike futures, the terms of forwards are negotiable. Counterparties can create forwards on a wide variety of underlying assets or variables.

An option gives you the choice to buy (with a call option) or sell (with a put option) something like stocks at a specific price (called the strike price) within a certain period (until the option expires). When you get an option, you pay a fee (premium) for each share to fix that strike price. The key thing about options, different from futures, is that you have the choice to buy or sell, but you’re not forced to. If it looks like you’ll make money, you can use (exercise) the option. But if not, you can just let it expire. If you don’t use the option, the only money you lose is the premium you paid at the beginning to secure that strike price.

Swaps are agreements where companies trade cash flows or financial terms with each other. These are not traded on regular exchanges but over-the-counter (OTC). Let’s look at two common types of swaps:

1. Interest Rate Swaps: Imagine two companies, A and B. Company A borrows $4 million at a variable or floating interest rate (which can change daily), while Company B borrows $4 million at a fixed interest rate (which doesn’t change). They might decide to swap these interest rate types through a bank that specializes in swaps. The bank charges them a fee for this service. This swap could lead to better interest conditions for both companies. Importantly, in this swap, only the interest payments are exchanged, not the principal amount (the total borrowed).
2. Currency Swaps: A currency swap involves trading the principal and interest of loans in different currencies. This is useful for companies making investments across borders, as it reduces the risk from changing exchange rates. For example, a U.S. company wants to start a subsidiary in Germany, and a German company wants to invest in the U.S. They can borrow in their own currencies and then swap through a bank specializing in currency swaps, which takes a small percentage of interest. This way, each company gets access to foreign currency without the risk of fluctuating exchange rates.

Understanding the difference between a security and a derivative can be tricky because derivatives are sometimes categorized as a type of security. This is technically accurate since “securities” is a term that encompasses a wide array of financial instruments.

Advantages:

1. Risk Hedging: Derivatives can be used to take opposite positions in a trade, helping to hedge or reduce risk.
2. Speculative Opportunities: They offer more significant opportunities for speculation, which can lead to higher profits (but also higher risks).
3. High Leverage: Futures and options typically require low margins, providing greater leverage – meaning you could potentially gain more from a small investment (but also lose more).

Disadvantages:

1. Complexity: Derivatives can be complicated and hard to understand, especially for beginners.
2. Risks for Inexperienced Traders: Due to their complexity, it’s easy for inexperienced traders to make poor decisions, potentially leading to significant losses.
3. Unlimited Risk Exposure: The high leverage in futures and options can expose traders to unlimited risk, potentially resulting in substantial losses.

The global derivatives market is enormous. The 2019 Bank for International Settlements (BIS) Triennial Central Bank Survey estimates that the global foreign exchange and over the counter (OTC) derivatives markets are both more significant and diversified than ever before, partly because of the increase of electronic and automated trading. Electronic trading reduces transaction costs and opens up markets to greater participant diversity.

Because derivatives contracts derive their value in different ways from their underlying assets, the actual size of the derivative market is challenging to estimate. Two measurements that stand out are notional value and gross market value.

• Notional value: Notional values are values of the underlying asset, but they’re looked at in different ways for different types of derivatives. For example, for futures contracts, notional amounts are the quantity of the asset multiplied by the spot price (the price in the contract). But for interest rate swaps, notional values are the amount of the principal — the money used to calculate the interest payments. According to the BIS, global notional amounts of OTC derivatives were $610 trillion in June 2021.
• Gross market value: Gross market value adds all absolute values of OTC derivatives, both positive and negative, at market values, on the date reported. The gross market value of OTC derivatives was $12.6T in June 2021, according to the BIS.