A derivative is the collective term used for a wide variety of financial instruments whose price derives from or depends on the performance of other underlying assets, markets or investments.
Along with stocks and debt, derivatives are one of the three main financial instruments. They are contracts between two or more parties which base their value on an underlying asset or assets. The most common types of contract are known as forwards, futures, options and swaps.
Historically used in agriculture, derivatives can now be based on almost anything. Popular contracts are based on underlying assets such as stocks, bonds, currencies, indexes and commodities.
A Brief History of Derivatives
Although these days based on currencies, stock markets and the like; derivatives have their roots in ancient history.
The basic methodology still used today for forward and futures contracts was being developed as far back as 4500 BC, when Sumerians used clay tablets to record the amount of a certain commodity to be delivered from one party to another at a certain point in the future.
This idea became a common method of agricultural trading and was not used for much else until as recently as the 20th century.
In 1970, the idea of a similar futures contract based on currencies and exchange rates was developed.
Championed by economist Milton Friedman, and helped by the establishment of floating exchange rates (where the relative value of two currencies is determined by supply and demand rather than government policy), the first foreign currency futures were officially introduced in 1972.
The principles behind what we would now term ‘call options’ also dates from ancient history. The first recorded example of such an idea dates from Greece in the 6th century B.C and involves olives.
Olives were crucial to the ancient Greeks, as they were pressed to make olive oil, which in turn provided nutrition and medicine.
Following a series of poor olive harvests, a philosopher named Thales of Miletus used his knowledge of astronomy to predict a strong harvest the following year.
He then paid a deposit for the right to rent out the local olive presses in the future. This didn’t cost him much because the previous poor harvests had driven down demand.
When the next harvest proved to be good, Thales had the rights to the olive presses and, as demand for them was now high, was able to rent them out to farmers at a profit. This is the essence of an options derivative.
Types Of Derivative
Derivatives can not only be based on different underlying assets, they can also take different forms. We’ve already encountered some of them above, but let’s define the most popular forms more clearly:
A forward contract is a private agreement between two parties to buy or sell an asset for a specific price on a specific date in the future. Because they do not have to be traded through an exchange, forwards are referred to as Over-the-Counter (OTC) products.
A futures contract is the similar to a forward contract in principle, but has two crucial differences: Firstly, futures contracts can only be traded through a public exchange. Because of this they are referred to as Exchange-Traded Funds (ETFs). Secondly, a futures contract’s value changes daily with the price of the underlying asset.
An option is different to both forward and futures contracts. It is a contract which gives a party the option to buy (call) or sell (put) a particular asset at a certain price, known as the strike price, by a particular date.
Swaps are derivatives used by companies and are not generally available to traders without significant capital, although some brokers do offer them. As implied by the name, a swap involves two parties exchanging financial instruments, such as interest rates, through a third party. How this works and creates profit is explained in our article here.
Hedging with Derivatives
Derivatives are a popular method of minimising risk, also known as hedging. The benefits of hedging with forward and futures contracts are in the security they offer.
For example: A building firm know that they will need to buy a large amount of raw materials in six months’ time. They expect material prices to rise but don’t have the capacity to buy and store now.
By buying a forward or futures contract, they can effectively freeze the current price for six months with the promise of delivery at the end of the contract. If the price goes up during the six months, they profit from the saving made.
Options too can be effective hedging tools: If a trader holds stock in a company but fears it will significantly decrease in value in the near future, they have two choices: they can sell their stock immediately, or they can hedge by buying a ‘put’ option on the said stock.
This gives them the right to sell their shares should they drop to a certain strike price before a given date. If the shares don’t reach the strike price before the end of the contract, the trader can keep them and only loses the money paid for the put.
Speculating with Derivatives
As we saw above with Thales and his oil presses, derivatives can also be a good way to make a profit. One of the main reasons for this in today’s markets is the amount of leverage derivatives can offer.
For example, an investor may only need to put down 10% of the value of a contract to open an options or futures position.
At the same time, any price movements in the underlying asset are magnified by derivatives because each contract represents multiple amounts of the asset for a cheaper price than buying the asset itself.
This means there is the potential for huge profit, but equally for huge loss.
Traders interested in derivative speculation should fully understand the maths and potential risks of options and futures contracts before investing. You can find more in-depth articles on how their profit and loss are calculated here and here.
Pros and Cons of Derivatives
To sum up, the main advantages of derivatives for traders are:
- Can help to hedge risk against price fluctuations
- Can offer greater leverage than trading in the underlying assets themselves
- Their liquidity makes it easy to open and close positions
Derivatives also come with inherent dangers, so much so that leading investor Warren Buffett has called them ‘financial weapons of mass destruction’. The key disadvantages are:
- Whilst leverage gives the potential for large profit, it can also mean the potential for equally large loss.
- Derivatives require a great deal of understanding and accuracy. If not used properly, they can create systematic risk for the company using them.
- Some OTC derivatives aren’t as well regulated as others. This exposes one side to risk if the other defaults.