What is a derivative?
Derivatives are interesting financial instruments. They are actually a kind of contract or agreement that helps two parties enter into a transaction for the right or obligation in relation to some asset. For example, one party has to sell something and another party has to buy it.
These financial instruments are cool because they reduce uncertainty. If you were offered one superpower to choose, and you would choose the ability to predict the future, then derivatives are for you. Of course, they can’t give you a 100% guarantee, nothing can, but they can help you reduce risk in your portfolio if used properly. However, you should note that they are very leveraged instruments so can massively increase risk if used improperly!
Now that you know what a financial derivative is, it’s time to go deeper and learn derivative contract characteristics, which are:
- the derivative price changes following the value of the underlying asset (rate, commodity, security, credit rating, etc.);
- the purchase of a derivative typically requires only a small initial cost (ie, they are leveraged);
- derivatives are settled in the future relative to the moment they are created;
- derivatives can be traded on an exchange but also over the counter;
- derivatives require margin to be posted during their life, so you may have to post more money than you initially paid.
The purpose of acquiring a derivative is to hedge price risk over time or to generate income from changes in the value of the underlying asset. But the result can be both positive and negative for the transacting parties.
As a derivative is a contract, there must be some information in writing. So, the contracts are drawn up with terms that can include the following content:
- name and contract parties;
- the asset of the derivative and characteristics – the type of security, its price and currency, circulation period, and other conditions;
- execution price, payment procedure, and number of underlying assets;
- type of contract (with or without delivery of the asset), the scope of the agreement;
- terms of agreement execution, the responsibility of the parties, disagreements, and disputes;
- addresses, signatures, and bank details.
What are the different examples of derivatives?
There’re four examples:
If these words are no more understandable for you than the elvish language, don’t worry, we are going to break them down.
Forward contracts are a kind of agreement between two parties for the purchase and delivery of some asset in the future. It’s important to mention that the price is agreed upon in advance.
Imagine you’re a farmer and you want to sell oranges. You get a mortgage to hire workers, pay the rent, and all the business stuff. You suggest that when you grow oranges and sell them (based on the current price), your gain will cover the mortgage.
The price ranges. If the harvest is large all around the world, then the oranges’ price will fall, and you have to ensure your business. It’s autumn, you make an agreement that you will sell oranges at today’s price (let’s say £1.5 for one packaging), and the second party will buy them from you. The next year has come, prices have risen or fallen, but you sell your oranges at the agreed price.
There’re also futures contracts or just futures. They are very similar to forwards but they are sold in derivatives markets (ie, exchange-traded) and parties will need a broker. By the way, the notional value of the derivatives market is considered to be over $1 quadrillion dollars on the high end.
Options are very interesting as well. Options give you the choice to buy or sell. Let’s return to oranges again. You’re still a farmer who wants to sell oranges, but now you make an agreement that you will sell oranges at today’s price, but the second party may buy them or not if the price on the market is lower. Your price is £1.5 for one packaging (the current price you are based on), and the market price is £1.4. Of course, it’s more profitable to buy for £1.4. That’s an option.
The last thing here is the swap. In simple words, it’s a contract based on the underlying transaction where two parties agree to exchange a set of payments. It is outside the scope of this article, so we’ll leave it there.
The two main aims of using derivatives are risk insurance (or hedging) and profit on speculation.
Why use investment derivatives?
The simple essence of derivatives is to combine risk insurance with the possibility of making a profit. Thus, today you can buy a product that half a year ago cost £100 for let’s say £70. Or you can only lose a prepayment of £10, rather than lose the cost of the price drop if buying the product in a regular transaction.
So, usually, the purpose of buying a derivative is not to physically obtain the underlying asset, but to hedge price or foreign exchange risk over time, or to generate speculative profits from changes in the price of the underlying asset. And it’s a kind of magic but the issuers of derivatives are not necessarily the owners of the underlying asset.
Where to buy derivatives?
Just as there are stock markets, there are also derivative exchange markets, which constitute a large segment of the financial system. With its help, investors neutralise risks in the stock markets and share and limit negative consequences. Financial derivatives instruments included in an investment portfolio help to reduce losses in case of unsuccessful developments in the market. Though they can also hugely increase losses if things go wrong or they were not suited to the portfolio.
Is it good to invest in derivatives?
As it happens with everything in our wonderful world, derivatives also have their own pros and cons. Let’s give them a look.
- reduce the cost of financial transactions, and minimise the amount of initial investment required to acquire the risk of owning a particular asset;
- reduce financial risks (hedging) and the uncertainty of future income and expenses;
- they provide leverage as they are often purchased on margin;
- they provide more room for speculative policy.
- leverage can be negative if the price moves in the opposite direction from the position;
- sensitivity to changes prior to expiration, such as the cost of ownership of the underlying asset and interest rates;
- the value of your derivative can depend on the other party to the derivative (counter-party risk).
Now that you know the main information about financial derivatives, we’d like to remind you that investing in derivatives can be even riskier than investing in underlying assets, as derivatives very often are used for speculation. Derivatives are considered complex instruments, so not for the faint-hearted! Experience is necessary to be successful in the derivative world.
In the Orca app you can create your first trading portfolio and start investing in underlying assets (but not derivatives) if you think you’re ready. By the way, check out how to get free shares with Orca.
Interesting bonus facts
According to legend, Thales of Miletus, a famous ancient Greek philosopher and mathematician, was constantly reproached by his enemies for the uselessness of science. He wanted to prove the opposite, and so in 596, when Thales observed that the course of the stars portended a large harvest of olives, he bought all the presses for olive oil in Miletus and Chios. After bringing in a really considerable harvest, he sold oil three times more expensive than usual. That’s how he punished the doubters and, thanks to his knowledge, earned a fortune.
And the derivatives similar to those we observe today appeared in Japan in the 18th century. Historians claim that along with cash items (such as rice) at fairs, peasants traded empty rice baskets between harvests. Such a basket was sold cheaper than a full one. But the seller vowed to fill it with rice after harvest for free. It was an analog of today’s futures, with the only difference that instead of a written agreement the seller’s basket was used.
- a derivative is an agreement between parties, according to which they are obliged or entitled to transfer assets or funds on time or before its occurrence at a certain cost;
- there are different types of financial derivatives: futures, forwards, options and swaps;
- you can buy derivatives on their own exchange markets.