What Is a Derivative, and How Does It Work?

Closeup of a derivatives screen showing up and downward movement of gas, oil, and other commodities
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The term derivative is often defined as a financial product—securities or contracts—that derive their value from their relationship with another asset or stream of cash flows. Most commonly, the underlying element is bonds, commodities, and currencies, but derivatives can assume value from nearly any underlying asset.

What Is a Derivative?

There are many types of derivatives and they can be good or bad, used for productive things or as speculative tools. Derivatives can help stabilize the economy or bring the economic system to its knees in a catastrophic implosion. An 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. They include speculating, hedging, and trading in commodities and currencies through futures contracts, options swaps, forward contracts, and swaps. When used correctly, they can supply benefits to the user. However, there are times that the derivatives can be destructive to individual traders as well as large financial institutions.

Common Types of Derivatives

Derivatives can be bought through a broker—standardized—and over-the-counter (OTC)—non-standard contracts. Counterparty risk is associated with derivative trading. This risk is the chance that the opposing party in a trade—deal—will not hold up their end of the contract. Derivatives can be traded as:

Futures Contracts

While futures contracts exist on all sorts of things, including stock market indices such as the S&P 500 or The Dow Jones Industrial Average, futures are predominately used in the commodities markets. These are all standardized—price, date, and lot size—and trade through an exchange. Also, all contracts settle daily. Unless the trader buys an offsetting trade, they have the obligation to buy or sell the underlying asset. Futures are frequently used for speculation.

Imagine you own a farm. You grow a lot of corn, so you need to be able to estimate your total cost structure, profit, and risk. You can go to the futures market and sell a contract to deliver your corn, on a certain date and at a pre-agreed upon price. The other party can buy that futures contract and, in many cases, require you to physically deliver the corn. For example, Kellogg's or General Mills, two of the world's largest cereal makers, might buy corn futures to guarantee they have sufficient upcoming raw corn to manufacturer cereal while simultaneously budgeting their expense levels so they can forecast earnings for management to make plans.

Forward Contracts

Forward contracts function much like futures. However, these are non-standardized contracts and trade OTC. Since they are non-standard the two parties can customize the elements of the contract to suit their needs. Forward contracts are valuable for hedging future costs. These contracts settle at the expiration—or end date. Like futures, there is an obligation of the party to buy or sell the underlying asset at the given date and price.

Airlines use futures to hedge their jet fuel costs, mining companies can sell futures to provide greater cash flow stability and know what they will get for their gold or other commodities, and ranchers can sell futures for their cattle. These contracts transfer the risk between willing parties leading to greater efficiency and desirable outcomes.

Derivative Options

Options give the trader just that, an option. They have the ability to buy or sell a particular asset for the agreed-upon price on or before—depending on if it is an American or European option—the expiration date. Options can get quite complex in the structure of calls and puts. Call options and put options, which can be used conservatively or as extraordinarily risky gambling mechanisms are an enormous market. Options trade on primarily on exchanges as standardized contracts, but you will find exotic options that trade OTC.

Practically all major publicly traded corporations in the United States have listed call options and put options. While they can be extremely risky for the individual trader, from a system-wide stability standpoint, exchange-traded derivatives such as this are among the least worrisome because the buyer and seller of each option contract enter into a transaction with the options exchange, who becomes the counterparty.

The options exchange guarantees the performance of each contract and charges fees for each transaction to build what amounts to a type of insurance pool to cover any failures that might arise. If the person on the other side of the trade gets in trouble due to a wipeout margin call, the other person won't even know about it.

Swaps

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 effectively turn fixed-rate debt into floating-rate debt or vice versa. They can reduce the chance of a major currency move making it much harder to pay off a debt in another country's currency. The effect of swaps can be considerable on the balance sheet and income results in any given period as they serve to offset and stabilize cash flows, assets, and liabilities (assuming they are properly structured).

Contracts for Difference (CFD)

CFDs work like the futures contracts listed above in most regards. Here, the two parties agree that the selling party will pay the difference in the value of an underlying asset at the closing of the contract to the buyer. This contract is a cash-settled deal and no physical commodities or goods will trade hands. CFD trades are not allowed in the U.S.

Subprime Derivatives

During the subprime meltdown, the inability to identify the real risks of investing in MBS—and other such securities—and properly protect against them caused a "daisy-chain" of events. This is where interconnected corporations, institutions, and organizations find themselves instantaneously bankrupt as a result of a poorly written or structured derivative position with another firm that failed, or in other words, a domino effect.

A major reason this danger is built into derivatives is because of counter-party 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 the deal that was struck.

If society allows people to use leverage to enter into all sorts of complex derivative arrangements, we could find ourselves in a scenario where everybody carries large values of derivative positions on their books only to find—when it's all unraveled—that there is very little actual value.

The problem becomes exacerbated because many privately written derivative contracts have built-in collateral calls that require a counterparty to put up more cash or collateral at the very time they are likely to need all the money they can get, accelerating the risk of bankruptcy. It is for this reason that billionaire Charlie Munger, longtime a critic of derivatives, calls most derivative contracts "good until reached for" as the moment you need to grab the money, it could very well evaporate on you no matter what you're carrying it at on your balance sheet.

Munger and his business partner Warren Buffett famously get around this by only allowing their holding company, Berkshire Hathaway, to write derivative contracts in which they hold the money and under no condition can they be forced to post more collateral along the way.