Derivatives are financial products that derive their value from a relationship to another underlying asset. These assets typically are debt or equity securities, commodities, indices, or currencies, but derivatives can assume value from nearly any underlying asset.
What Is a Derivative?
There are many types of derivatives, but they all represent a means of managing risk. For example, a business that relies on a particular 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 is able to lock in a price for a specified period of time.
In this example, the derivative is the contract, and the underlying asset is the resource being purchased. If the price of the resource rises more than expected during the length of the contract, the business will have saved money. If the price drops or rises less than expected, the business will have lost money. However, in some cases, a small loss might be considered an acceptable cost for price stability.
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 in catastrophic fashion. 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, including 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 that 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 predominantly in commodities markets. They represent an agreement to purchase a commodity at an established price at a specified date in the future. They are standardized by price, date, and lot size and traded through an exchange. Also, all contracts settle daily.
Forward contracts function much like futures. However, these are nonstandardized contracts and 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. But unlike futures, these contracts settle at the expiration, or end, date—not daily.
Options give a trader just that—an option to buy or sell a particular asset for an agreed-upon price by a specified time.
Options trade primarily on exchanges such as the Chicago Board Options Exchange or the International Securities Exchange as standardized contracts.
Options can be risky for individual traders, but exchange-traded derivatives such as this are guaranteed by the Options Clearing Corporation (OCC), 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 effectively 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 can be considerable on the balance sheet as they serve to offset and stabilize cash flows, assets, and liabilities.
An example of the risks that come with 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 found themselves instantaneously bankrupt as a result of a poorly written or structured derivative position with other firms that failed.
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 a deal.
When leverage is used to enter complex derivative arrangements, banks and other institutions can carry 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.
- Derivatives can be used for speculation, such as buying a commodity in advance if you think the price is likely to rise soon.
- Derivatives can be used to hedge risk by entering into a longterm contract at a fixed price for a commodity with a volatile price.
- There are several types of derivatives.
- The subprime mortgage crisis is an example of the risk involved with derivatives.