What Is a Derivative, and How Does It Work?

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The term derivative refers to a financial product that derives its value from its 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 and they can be used as speculative tools or to hedge risk. Derivatives can help stabilize the economy—or bring it 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, 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.

Common Types of Derivatives

Derivatives can be bought through a broker as "exchange-traded" or standardized contracts. You can also buy derivatives in over-the-counter (OTC), non-standard contracts.

Counterparty risk is associated with derivative trading, meaning you run the chance that the opposing party in a trade 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 predominantly used in the commodities markets. These are standardized—price, date, and lot size—and traded 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 also used for speculation.

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, often leading to greater efficiency and desirable outcomes.

Forward Contracts

Forward contracts function much like futures. However, these are non-standardized contracts and trade OTC. Since they aren't standardized, the two parties can customize the elements of the contract to suit their needs.

Forward contracts are valuable for hedging future costs. 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

Options give the trader just that—an option. Options give you the ability to buy (call) or sell (put) 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.

While options can be very risky for the individual trader, exchange-traded derivatives such as this are guaranteed by the Options Clearing Corporation, a clearinghouse that issues and clears options contracts and which is registered with the Securities and Exchange Commission. The buyer and seller of each option contract enter into a transaction with the options exchange, who becomes the counterparty. In effect, the OCC is the buyer to the seller and the seller to the buyer.

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 as they serve to offset and stabilize cash flows, assets, and liabilities (assuming they are properly structured).

Contracts for Difference (CFD)

CFDs work like futures contracts 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 banned in the U.S. and not executed on U.S. exchanges. They are extremely risky, and some are marketed to retail investors by scammers looking to make a quick buck.

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. Interconnected corporations, institutions, and organizations found themselves instantaneously bankrupt as a result of a poorly written or structured derivative position with another firm that failed—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.

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. As billionaire Charlie Munger, a Warren Buffet partner and longtime critic of derivatives, put it, derivatives contracts are often only "good until reached for."

The Bottom Line

Trading derivatives is not for the beginner. To protect yourself, it's important that you are educated on the various risks of these trades, how they work, and what your obligations are.

Article Sources

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  4. Commodity Futures Trading Commission. "CFTC Glossary." Accessed April 29, 2020.

  5. Commodity Futures Trading Commission. "Basics of Futures Trading." Accessed April 29, 2020.

  6. Commodity Futures Trading Commission. "Economic Purpose of Futures Markets and How They Work." Accessed April 29, 2020.

  7. U.S. Department of the Treasury. "Derivatives." Accessed April 29, 2020.

  8. Investor.gov. "Options." Accessed April 29, 2020.

  9. SEC.gov. "Options Trading." Accessed April 29, 2020.

  10. The Options Clearing Corporation. "Understanding Stock Options," Page 5. Accessed April 29, 2020.

  11. ISDA.org. "OCC (Options Clearing Corporation)." Accessed April 29, 2020.

  12. California State Treasurer. "Understanding Interest Rate Swap Math & Pricing," Page 2. Accessed April 29, 2020.

  13. State Corporation Commission. "SCC Urges Virginia Investors to Be Wary of Contracts for Difference." Accessed April 29, 2020.

  14. Testimony of Michael Greenberger, Law Professor, University of Maryland School of Law. "The Role of Derivatives in the Financial Crisis," Page 18. Accessed April 29, 2020.

  15. Warren Buffet. "Warren Buffett on Business: Principles from the Sage of Omaha," Page 63. John Wiley & Sons, 2009.