Derivatives

In finance, a derivative is a contract that includes two or more parties whose value is based on underlying assets. It is used to hedge or speculate risk on price movements. An important part of derivatives is that they don’t need to physically own the underlying assets, but these contracts are still exposed to market movements. That’s their main benefit, traders don’t need to have ownership in underlying assets to be exposed in that specific market. Instead, these contracts have lower barriers of entry, reduced risk, and market exposure.

What Are Derivatives?

Hedging

Hedging is protecting oneself against unfavorable price movements. For example, if an airline believes oil prices will rise, they will lock in prices now to stabilize future outcomes. They sacrifice favorable market movements for less downside risk.

Speculation is the belief that prices will be in your favor in the future, in which they seek to profit from uncertainty. For example, if the airline believes oil prices will rise, the trader will bet that it will fall and if they’re correct they’ll make a profit.

The video by MoneyWeek gives a great introduction to derivatives. I highly recommend giving it a quick watch before you continue reading, as it’s great background knowledge and you’ll be less confused about what I’m going to discuss in this blog.

How Derivatives Work

Traders use derivatives to access specific markets and trade different assets that may be hard to normally obtain. They can be traded over the counter (OTC) or in a market exchange. Over the counter contracts may have some drawbacks, as contracts are privately made, there is a chance that one of the parties may not deliver its obligations, or default.

HISTORY OF DERIVATIVES

Derivatives were originally used for the fluctuation of national currencies, where it ensured balanced exchange rates for internationally traded goods. For example, if a U.S. investor buys shares of a Japanese company, but the yen weakens versus USD, the investor’s returns will shrink when they convert back to USD. This is known as exchange rate risks. To hedge it, they may lock in an exchange rate contract today for a future date, or future currency exchange rates.

Nowadays it has multiple purposes besides just mitigating exchange rate risks. As long as there is risk to an asset, a company and hedge those existing risks. There are four types of these derivative contracts: Futures, Forwards, Options, and Swaps.

Futures Contracts

Also referred to as “Futures”, it is an agreement to purchase and deliver an asset at an agreed upon price at a future date. Although they’re similar to Forward Contracts, Futures are the standardized contracts traded in an exchange market. That means the two parties can’t just not deliver their obligations, or default randomly. They are obligated to deliver their promises in buying and selling the assets. Let’s take a look at this example:

Company A purchases a future contract with Company B, where Company A can purchase Steel for $1000 per ton from Company B. The contract expires December 1st, 2026 and is created on January 20th, 2025. If Steel prices were to rise to $1500 per ton, Company B must fulfill their promises at selling $1000 per ton until the contract expires. If Company A fulfills their need for Steel, they can also sell the contract itself and keep the profits. If the prices of Steel drop to $500 per ton, Company A will still have to pay $1000 to Company B for steel.

Both parties have a benefit, if Company A is correct in that steel prices will rise, they will pay less than what it will actually cost. If Company B is correct in that prices will fall, Company A will have to pay them more. Although the reality is often nuanced, as contracts themselves can be sold before the expiration date occurs. If Company A realizes they would lose a lot of money, they can sell the contract at the total loss, since if the prices were to drop further, they could get a better deal than just staying in the contract.

Forwards contracts

Also referred to as “Forwards”, it is also an agreement to purchase and deliver an asset at an agreed upon price at a future date. Technically there are only three types of derivatives, as Futures and Forwards are combined, with only one major difference. The difference is that unlike futures, forwards are traded OTC, meaning there is a risk that one of the parties will fail to deliver its obligations, or even default. The main benefit for companies to do forward contracts is the ability to negotiate in private. That of course has its own risk on top of the core risks in futures contracts.

Options Contracts

Options contracts is an agreement between two parties to purchase or sell an asset at a future date for a specific price. However, the rule with options contracts is that the buyer has the right but not the obligation to buy or sell. What does this mean? Let’s look at this example:

An investor owns 10 shares of a stock worth $10 per share. The investor believes the stock’s value will rise, but still wants to hedge the risk of it dropping. They buy a put option that costs $1 per share, so it costs $10 in total to enter this trade. If the stock falls to $8 per share, the investor has the right, but not the obligation to sell at $10 per share until the expiration date. If they do, they only lose $10, instead of the $20 if they decided to not enter the put option trade. If the stock rises to $12 per share, the investor doesn’t have to sell at $10 per share, instead they can let the option expire and sell at $12. It costs $10 to hedge, but they gained $10 after those costs.

The main focus is that the counterparty will always gain $10, but they also hope that the value of the stock will also rise so that they aren’t overpaying the stock’s value if it were to drop. The investor only cares about minimizing losses, so even if the value drops, they wouldn’t lose as much as they would if they weren’t in the option contract.

To go even further, look at the chart. As we can see, options are also categorized into Calls and Puts. Calls are known to be bullish, so investors believe prices will increase. On the other hand, Puts are known to be bearish, so investors believe prices will decrease.

Swaps

Used to exchange one kind of cash flow for another. Remember that cash flows can include currency, interest rates, credit default, and commodities, just to name a few. The core idea is that one party pays a fixed rate and the counterparty pays a floating rate. These types of derivatives are OTC, so they also carry the risk of a party not meeting its obligations or defaulting.  Let’s look at an example:

Company A has a loan with a floating rate of 5%, in which they are scared that the interest rates may rise. They enter a swap with Company B, where Company B is willing to exchange payments at a fixed rate of 6%. So Company A will pay a fixed rate of 6% to Company B on the $1000 principal, and Company B will pay Company A 5% of the $1000 principal. If the rates were to rise to 7%, Company B will pay Company A 1% difference. Conversely, if rates were to fall to 4%, Company A will pay Company B the 2% difference.

It might seem weird that Company B would agree to this, but the core idea is there with Hedging and Speculation. Company B would agree to this contract if they believe that the Interest Rates will fall. Company A’s main goal is to have a fixed rate, they’re not hoping to make money from interest rates rising, but if they do, it’s a bonus.