What is a Derivative?

Derivatives are trades that balance risk with reward by making the value of the trade contingent on the ability of an asset to float in value over the life of the contract. This article will define derivatives and review examples of the most common kinds of derivatives.

What is a derivative?

A derivative is a contractual agreement between two parties. The value of the derivative is determined by the value of an underlying asset such as stocks, bonds, commodities (oil, wheat, soybeans, etc.) or precious metals (gold, silver, etc.). But while derivatives are most commonly thought of as referring to tangible assets, they can also be arranged between intangible assets like the weather.

When two parties enter into a derivative contract it does not necessarily imply that they have ownership of the physical asset. In many cases, derivatives are used to provide liquidity to markets. For example, when two parties create a futures contract for oil, it’s likely that neither party has physical possession of the thousands of barrels that might be specified in the contract. However, they are trading the right to trade those barrels to another party for a specified price.

The essential concept behind a derivative instrument is the ability of one party to speculate on the future direction of an asset and profit from price changes, and the other party to shift or manage risk. The party that is looking to manage risk may be said to be hedging.

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Derivatives are either traded on national stock exchanges or traded over-the-counter (OTC). When they are traded on national exchanges, they are regulated by the U.S. Securities and Exchange Commission (SEC). OTC derivatives are negotiated between two parties. Because of the complexity and risk involved in derivatives most derivative contracts are made between institutional investors.

Types of derivatives

A derivative takes on many different forms. Among the most common types of derivatives are futures contracts, options trading (such as call options and put options), swaps, and warrants. Each of these takes the concept of a derivative from a different angle.

1. Options trading– This type of derivative is where a buyer and a seller agree to trade an asset at a specific price at a specific time. The nature of the option will depend on whether a call option or put option is used.
   
   In a call option, the owner of the option is the buyer. They are buying the right to buy a specific quantity of an asset at an agreed-upon price at a certain date. The seller is obligated to sell the asset at that price on the expiration date should the buyer decide to “call” the option.
   
   For example, during hurricane season an investor may initiate a call option for Home Depot (NYSE: HD) on the speculation that hurricane damage may cause sales of plywood and other necessities before the storms hit and for building materials after the storms have passed. The price of the stock is $150, however, the investor really believes the stock will go to $170 or even higher. For this reason, they may initiate a contract with a call option of $160 high enough to attract interest but with enough room for profit. If he finds a seller, then he will purchase a call option. Usually, call options to require the purchase of at least 100 shares. They also require a premium to be paid to the seller. This is usually a nominal fee of a few dollars per share. So, in this case, the buyer will agree to pay the seller $16,000 for 100 shares of Home Depot stock and an additional $200 as a premium to buy the contract. At this point, two outcomes can happen:
   
   If Home Depot’s stock rises past $160, the buyer will exercise his option and the seller will sell him the 100 shares for $16,000. The buyer can then sell the shares for their market value and collect a profit off the trade.
   
   If the stock price remains below $160, the buyer can simply allow the option to expire. The only money the buyer is out the premium he paid to purchase the option. In this case, the premium is $200.
   
   A put option is similar to a call option, but the roles of buyer and seller are reversed. In the case of a put option, the owner of the contract is the seller. In a put option, the seller is buying the right (but once again, not the obligation) to sell a buyer a specific quantity of an asset for an agreed-upon price before the option’s expiration date. In the case of a put option, the seller pays the buyer a premium to enter the contract.
   
   The motivation behind a put option is insurance against a price move by the seller. For example, an investor owns shares in Honda Motor Co Ltd. (NYSE: HMC). The investor hears about a possible recall on one of the company's most popular models. They are concerned that the price of the stock may drop and want to put a hedge on their investment before it drops to a level where they lose any of their capital gains. The stock is currently trading at $27. They put a put order out for $24. If they attract a buyer, they pay the buyer a premium, in this case, $150 and they wait.
   
   If the stock price drops below $24, the owner of the option would “put” the option to the buyer who would have to buy $100 shares at $2,400. The owner of the option would have made $2,400 minus the $150 they paid for a total of $2,250.
   
   If the stock price remains above $24, the owner of the option can simply allow it to expire and the only money they will have lost is their premium of $150.
   
   Here’s a summary of the differences between call options and put options.

2. Swaps – This type of derivative is where a buyer and seller make a contract to exchange what can best be described as a cash flow sequence. In a swap arrangement, one of the cash flows has uncertainty about its value that could change its direction. In this way, a swap requires one party to take a long position in one instrument while the other party takes a short position in the same instrument. Two of the most common types of swaps are interest rate swaps and currency swaps.
   
   In an interest rate swap, a buyer and a seller agree to exchange cash flow on financial instruments, such as loans, where one loan has a fixed rate and the other has a floating rate. For example, Company A issues $1 million in five-year bonds that have a variable annual interest rate of 2%. They are convinced that interest rates are going to rise significantly which would affect their interest payment. They want to get the cost certainty that comes with a fixed interest rate. Company B is convinced that interest rates are not going to increase dramatically so they enter into a swap with Company A. The details might look like this:
   
   Company B agrees to fund Company A’s fund their interest payments on the bond issue at the current rate of 2% and will pay Company A an additional 1.3% interest.
   
   Company A agrees to pay Company Y a fixed interest rate of 6% on a notional value of $1 million over five years (note: no actual principal changes hands).
   
   If interest rates rise, Company A stands to profit because their interest rate is locked in. Conversely, if interest rates stay the same, or increase only slightly, Company Y will benefit because they are receiving more from Company A then they are paying out. 
   
   In a currency swap, companies are looking to take advantage of loan rates in their home countries while ensuring themselves against changing currency rates in foreign countries where they do business. The simplest way to illustrate this is with two companies who do business in their home countries as well as the other company's country. By entering into a currency swap, each company can take out a loan in their home country and then swap the loans so each can get the funds they need in the currency they need. In return, the two companies agree to pay the interest on each other's loans in their home currency.
   
   
3. Futures contract– This type of derivative is similar to an options contract but tends to focus on commodities that contain a high degree of price volatility and systematic risk. Futures contracts are designed to move large volumes of an asset to provide liquidity in the market. Two important ways that future contracts differ from options is that the contract must be executed on the expiration date; there is no “option” to let the contract expire. Another difference is that futures contracts must be settled each day. This usually involves the use of margin accounts which must be kept funded in the event the trade is not working in one party’s favor.
   
   For example, if oil is priced at $60 per barrel in February, a seller who sees positive economic news may accept a futures contract for September or October to sell 100 barrels of crude oil at a price of $65. Assuming he finds a buyer, the seller is now committed to receiving $6,500 from the buyer on the contract date regardless of the price in the market.  At this point, one of two scenarios could happen.
   
   If the price of oil goes up and closes at $70 per barrel, the seller has lost $500 ($5 x 100) because of the increased price. Subsequently, the buyer has profited by $500 because they have locked into a price that is lower than the current price.
   
   The price of oil only rises to $60 per barrel, the seller has gained $500 and the buyer has lost $500 because they are obligated to pay the seller at the rate of $65 per barrel.
   
   
4. Warrants– This type of derivative is nearly identical to an option, but warrants are issued directly by companies, whereas options are available on central exchanges. Like options, there are call warrants and put warrants. A company will frequently include warrants when they offer new shares as a way to entice buyers into buying the new shares.

The bottom line on derivatives

Derivatives have gotten a bad reputation and not without some reason. Speculation in derivatives was rampant during the junk bond crisis of the late 1980s. Similar speculation led to the bubble culture that resulted in the tech stock crash of the early 2000s, and the housing crisis that served as a catalyst for the Great Recession of 2007.

Derivatives are based on the concept of risk versus reward. One side is assuming risk in hopes of a larger gain. The other party is trying to provide a hedge against risk by locking in a price, even if it means they may forfeit larger gains. In effect, they are using a derivatives contract as a form of insurance.

Despite their reputation, derivatives do play an important role in providing liquidity to financial markets. For many producers, derivatives are a way of ensuring profits, particularly in volatile markets.

The most common types of derivatives are futures contracts, options, swaps, and warrants. Each type operates slightly differently and is based on different investment objectives. All derivative trading carries some form of risk and, with the exception of options trading, is usually carried out by large institutional investors who have the cash reserves to offset the risk.