Definition and Example of a Derivative
There are many types of derivatives. Derivatives can be effective at managing risk by locking in the price of the underlying asset. For example, a business that relies on a certain resource to operate might enter into a contract with a supplier to purchase that resource several months in advance for a fixed price. If it is a resource with a market value that fluctuates regularly, the business can lock in a price for a certain period of time.
In this case, the derivative is the contract. The underlying asset is the resource being purchased. If the market price of the underlying rises more than expected during the length of the contract, the business will save money, since the asset can be purchased at the lower, fixed price of the contract. If the market price drops or rises less than expected, the business will have lost money, since it will purchase the underlying asset at the higher-than-market derivative contract price.
Companies often use derivatives to lock in the purchase price of raw materials needed for the production of their goods. By locking into the derivative contract, a company doesn't need to worry about the price of a raw material rising, which would decrease the company's profitability. In some cases, a small loss might be acceptable for price stability. Derivatives can be used for the purchase of commodities, including copper, aluminum, wheat, sugar, and oil.
How Derivatives Work
Derivatives can be used as speculative tools or to hedge risk. They can help stabilize the economy—or bring it to its knees. One example of derivatives that were flawed in their construction and destructive in their nature are the infamous mortgage-backed securities (MBS) that brought on the subprime mortgage meltdown of 2007 and 2008.
Typically, derivatives require a more advanced form of trading. These include speculating, hedging, options, swaps, futures contracts, and forward contracts. When used correctly, these techniques can benefit the trader by carefully managing risk. However, there are times the derivatives can be destructive to individual traders as well as to large financial institutions.
Types of Derivatives
Derivatives can be bought through a broker as "exchange-traded" or standardized contracts. You also can buy derivatives in over-the-counter (OTC), nonstandard contracts.
Futures contracts are used primarily traded in commodities markets. They represent agreements to purchase commodities at set prices at specified dates in the future. They are standardized by price, date, and lot size and traded through an exchange, and they settle daily.
Forward contracts function much like futures. These are nonstandardized contracts. They trade over-the-counter. Since they aren't standardized, the two parties can customize the elements of contracts to suit their needs.
Like futures, there is an obligation to buy or sell the underlying asset at the given date and price. However, unlike futures, these contracts settle at the expiration, or end, date—not daily.
Options give a trader just that. They confer an option to buy or sell a particular asset for an agreed-upon price by a set time.
Options trade mostly on exchanges, such as the Chicago Board Options Exchange or the International Securities Exchange as standardized contracts.
Options can be risky for individual traders. Exchange-traded derivatives such as this are guaranteed by the Options Clearing Corporation (OCC). This is a clearinghouse registered with the Securities and Exchange Commission. The buyer and seller of each option contract enter into a transaction with the options exchange, which becomes the counterparty. In effect, the OCC is the buyer to the seller and the seller to the buyer.
Companies, banks, financial institutions, and other organizations routinely enter into derivative contracts known as "interest rate swaps" or "currency swaps." These are meant to reduce risk. They can turn fixed-rate debt into floating-rate debt or vice versa. They can reduce the chance of a major currency move, making it more difficult to pay off a debt in another country's currency. The effect of swaps on the balance sheet can be considerable. They serve to offset and stabilize cash flows, assets, and liabilities.
Risks of Derivatives
Although derivatives can be helpful, there are some risks associated with these contracts, some of which are outlined below.
Lack of Transparency
An example of the risks of derivatives can be found in the events that led to the subprime mortgage crisis. The inability to identify the real risks of investing in mortgage-backed securities and other securities and properly protect against them caused a daisy chain of events. Interconnected corporations, institutions, and organizations went bankrupt due in part to poorly written or structured derivative positions with other firms that failed.
One major risk of derivatives is counterparty risk. Most derivatives are based on the person or institution on the other side of the trade being able to live up to their end of a deal. If the counterparty suffers financially, it may be unable to perform its part of the contract.
Leverage is the process of using borrowed funds to purchase investments. When leverage is used to enter complex derivative arrangements, banks and other institutions can carry large values of derivative positions on their books. If the market or counterparty performs poorly when it's all unraveled, there might be very little value associated with the contract.
The problem can grow, since many privately written derivative contracts have built-in collateral calls. These require a counterparty to put up more cash or collateral at the very time when they're in financial need, which can exacerbate the financial difficulties and increase the risk of bankruptcy.
As a result, derivative losses can hurt corporations, individual investors, and the overall economy, as in the case of the Financial Crisis of 2007 to 2008.
- Derivatives can be used for speculation, such as buying a commodity contract with the expectation that the price will rise in the future.
- Derivatives can also be used to hedge risk, such as a company that enters into a contract at a fixed price for a commodity with a volatile price.
- Types of derivatives include options contracts, which give the holder the right, but not the obligation, to buy or sell the underlying security.
- The subprime mortgage crisis of 2007 and 2008 is an example of the risk involved with derivatives.