What is a ‘Derivative’
A derivative is a security with a price that is dependent upon or derived from one or more underlying assets. The derivative itself is a contract between two or more parties based upon the asset or assets. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.
Derivatives either be traded over-the-counter (OTC) or on an exchange. OTC derivatives constitute the greater proportion of derivatives in existence and are unregulated, whereas derivatives traded on exchanges are standardized. OTC derivatives generally have greater risk for the counterparty than do standardized derivatives.
BREAKING DOWN ‘Derivative’
Originally, derivatives were used to ensure balanced exchange rates for goods traded internationally. With differing values of different national currencies, international traders needed a system of accounting for these differences. Today, derivatives are based upon a wide variety of transactions and have many more uses. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.
Because a derivative is a category of security rather than a specific kind, there are several different kinds of derivatives in existence. As such, derivatives have a variety of functions and applications as well, based on the type of derivative. Certain kinds of derivatives can be used for hedging, or insuring against risk on an asset. Derivatives can also be used for speculation in betting on the future price of an asset or in circumventing exchange rate issues. For example, a European investor purchasing shares of an American company off of an American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros. Additionally, many derivatives are characterized by high leverage.
Common Forms of ‘Derivative’
Futures contracts are one of the most common types of derivatives. A futures contract (or simply futures, colloquially) is an agreement between two parties for the sale of an asset at an agreed upon price. One would generally use a futures contract to hedge against risk during a particular period of time. For example, suppose that on July 31, 2014 Diana owned ten thousand shares of Wal-Mart (WMT) stock, which were then valued at $73.58 per share. Fearing that the value of her shares would decline, Diana decided that she wanted to arrange a futures contract to protect the value of her stock. Jerry, a speculator predicting a rise in the value of Wal-Mart stock, agrees to a futures contract with Diana, dictating that in one year’s time Jerry will buy Diana’s ten thousand Wal-Mart shares at their current value of $73.58.
The futures contract may in part be considered to be something like a bet between the two parties. If the value of Diana’s stock declines, her investment is protected because Jerry has agreed to buy them at their July 2014 value, and if the value of the stock increases, Jerry earns greater value on the stock, as he is paying July 2014 prices for stock in July 2015. A year later, July 31 rolls around and Wal-Mart is valued at $71.98 per share. Diana, then, has benefited from the futures contract, making $1.60 more per share than she would have if she had simply waited until July 2015 to sell her stock. While this might not seem like much, this difference of $1.60 per share translates to a difference of $16,000 when considering the ten thousand shares that Diana sold. Jerry, on the other hand, has speculated poorly and lost a sizeable sum.
Forward contracts are another important kind of derivative similar to futures contracts, the key difference being that unlike futures, forward contracts (or “forwards”) are not traded on exchange, but rather are only traded over-the-counter.
Swaps are another common type of derivative. A swap is most often a contract between two parties agreeing to trade loan terms. One might use an interest rate swap in order to switch from a variable interest rate loan to a fixed interest rate loan, or vice versa. If someone with a variable interest rate loan were trying to secure additional financing, a lender might deny him or her a loan because of the uncertain future bearing of the variable interest rates upon the individual’s ability to repay debts, perhaps fearing that the individual will default. For this reason, he or she might seek to switch their variable interest rate loan with someone else, who has a loan with a fixed interest rate that is otherwise similar. Although the loans will remain in the original holders’ names, the contract mandates that each party will make payments toward the other’s loan at a mutually agreed upon rate. Yet, this can be risky, because if one party defaults or goes bankrupt, the other will be forced back into their original loan. Swaps can be made using interest rates, currencies or commodities.
Options are another common form of derivative. An option is similar to a futures contract in that it is an agreement between two parties granting one the opportunity to buy or sell a security from or to the other party at a predetermined future date. Yet, the key difference between options and futures is that with an option the buyer or seller is not obligated to make the transaction if he or she decides not to, hence the name “option.” The exchange itself is, ultimately, optional. Like with futures, options may be used to hedge the seller’s stock against a price drop and to provide the buyer with an opportunity for financial gain through speculation. An option can be short or long, as well as a call or put.
A credit derivative is yet another form of derivative. This type of derivative is a loan sold to a speculator at a discount to its true value. Though the original lender is selling the loan at a reduced price, and will therefore see a lower return, in selling the loan the lender will regain most of the capital from the loan and can then use that money to issue a new and (ideally) more profitable loan. If, for example, a lender issued a loan and subsequently had the opportunity to engage in another loan with more profitable terms, the lender might choose to sell the original loan to a speculator in order to finance the more profitable loan. In this way, credit derivatives exchange modest returns for lower risk and greater liquidity.
Another form of derivative is a mortgage-backed security, which is a broad category of derivative simply defined by the fact that the assets underlying the derivative are mortgages.
Limitations of Derivatives
As mentioned above, derivative is a broad category of security, so using derivatives in making financial decisions varies by the type of derivative in question. Generally speaking, the key to making a sound investment is to fully understand the risks associated with the derivative, such as the counterparty, underlying asset, price and expiration. The use of a derivative only makes sense if the investor is fully aware of the risks and understands the impact of the investment within a portfolio strategy.