What are Derivatives?

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A derivative is a financial instrument or security that attempts to replicate the price of another asset, or the underlying asset. Derivatives can be highly leveraged instruments, futures and options are derivatives

A significant reason for the creation of derivatives was to give market participants the ability to hedge risk. Speculation using derivative securities has become popular since their emergence on the financial scene.

Commodity futures and options attract many speculators.

Corn futures were created to provide farmers with a hedging mechanism when it comes to an adverse price move in the corn market. These futures provide farmers with the ability to sell corn futures contracts (which are the derivatives) to lock in a price before harvest, while the corn is still in the planting or growing stage. When a farmer locks-in the current market price for their corn via the futures market, they swap the current market price for the unknown future price. The farmer forgoes additional profit if the corn price rises when hedging with futures to protect against the potential for a decline in the price of the grain.

Derivatives can be highly leveraged; this means that a small amount of money can control a large position which is why they are attractive financial instruments for many speculators. Speculators look to gain huge profits from relatively small price moves.

There are two sides to this coin, where there is the potential for rewards, risks exist. A speculator trading leveraged derivatives will assume a higher degree of risk in exchange for the profit potential. When they are wrong, losses can be devastating. Speculators add liquidity to the derivatives markets as they tend to trade at all price levels.

Liquidity would suffer in the absence of speculators. Investors and speculators can adjust leverage levels in positions that are suitable for their risk profiles. Think of it this way, consumers want to buy when prices are low and producers wish to sell when they are high. If it were not for speculators, producers and consumers would have a hard time agreeing on a fair price. The speculator's role is to act as a facilitator of risk transfer.

As derivatives, futures and options have allowed for the development of many sophisticated financial instruments. Derivative positions during the years leading up to the home price and mortgage-backed security issues in the U.S. in 2008 resulted in a financial crisis. Derivatives can be dangerous financial instruments without proper attention to risk and a proper and effective regulatory environment.

The benefits outweigh drawbacks when it comes to derivates; they provide hedgers with the ability to manage risk. Derivatives give investors and speculators the ability to participate in many assets and add liquidity to global markets across all asset classes. 

Derivatives Replicate Underlying Assets

In the world of commodities, everything begins with the physical.

Commodity production occurs in areas of the world that support the growth of crops and where geology is such that reserves of metals, hydrocarbons or other minerals occur naturally. While commodity production is locationally specific, consumption is widespread. Every person on the planet is a consumer of staple commodities in some form. Think of the commodities markets as a pyramid. The physical raw material is at the top of the structure and under it are the derivatives that seek to replicate price action in the actual commodity. The further down you go on the pyramid, the more price discrepancies occur between the derivative instrument and the physical commodity.

Derivative instruments include forwards, swaps, futures, options and ETF and ETN products. These vehicles attempt to replicate the price action of the actual physical commodity.

To truly understand the derivatives, a trader or investor must do his or her homework. The first step is to understand the supply and demand characteristics of the underlying physical commodity represented by the derivative. The second step is to understand and analyze if the derivative does a good job replicating the price action in the physical market. Some do a great job; the gold ETF GLD is a great example of a derivative that has a high degree of correlation with price action in the physical gold market. Others do not do such a good job. When a derivative does not do a good job, the risk increases as market participants choose derivative instruments with the hope of replicating price action. Another consideration is timing. Some derivatives do a reasonable job tracking prices of the underlying asset on a short-term basis but not in the medium or long-term. Do your homework and make sure that the derivative instrument you select meets your specific requirements when it comes to the time horizon of a long or short position in the markets. 

It is not easy to replicate the prices of physical commodities because of term structure. The design of many futures contracts is such that they are derivatives that become physical on expiration. The delivery mechanism in futures causes prices to converge with physical prices naturally as longs and shorts have the ability to make or take the actual commodity. That is why futures with the ability to make or take delivery are close to the top of the pyramid. The delivery mechanism results in convergence where the derivative can become the physical during the delivery period.