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  • Writer's picturePeak Frameworks Team

Derivatives: Types of Derivatives, Concepts, and Risks

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What are Derivatives?

Derivatives are financial instruments that derive their value from underlying assets (such as stocks, bonds, commodities, currencies, interest rates, and market indexes).

For example, an option is a derivative that derives its value from a stock.

The advent of derivatives in the 1970s marked a significant milestone in global finance, offering a structured risk management approach and fostering efficient price discovery. These complex instruments enable investors to hedge risks, speculate on future price movements, and exploit arbitrage opportunities.

Core Concepts and Characteristics of Derivatives

Fundamentally, derivatives are contracts between two or more parties.

The value of these contracts depends on the price of the underlying asset.

They serve as an agreement to buy or sell the asset at a future date at a predetermined price. This mechanism allows businesses and investors to manage risk by securing a certain price level, thus protecting against adverse price movements.

For example, consider an airline company that consumes vast amounts of jet fuel. To protect itself from potential increases in fuel prices, the company might enter into a futures contract, agreeing to buy fuel at a specific price at a future date.

This strategy, known as hedging, is one of the primary uses of derivatives. It helps companies mitigate the risk of price volatility in the commodities they need for their operations.

Different Types of Derivatives

Types of Financial Derivatives
Source: The Motley Fool

Futures

Futures are standardized contracts to buy or sell an underlying asset at a predetermined price on a specific future date. They are traded on exchanges and used by businesses and investors to hedge risk or speculate on price movements.

For example, in April 2020, WTI Crude oil futures prices briefly dipped into negative territory due to an unexpected demand shock caused by the COVID-19 pandemic. The incident highlighted the inherent risk of futures contracts. While they can offer protection against price changes, they can also lead to substantial losses if the market moves against the contract holder.

Options

Options contracts offer the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a predetermined price before a certain date. Options allow investors to hedge their positions or speculate on the direction of asset prices with limited downside risk.

During the 2008 financial crisis, put options (which give the holder the right to sell at a specific price) on mortgage-backed securities and major stock indexes increased in value dramatically as the market plummeted. Investors who held these options were able to offset some of their losses from the downturn.

Swaps

Swaps are agreements between two parties to exchange sequences of cash flows for a set period. The most common types are interest rate swaps and currency swaps. Interest rate swaps allow parties to exchange fixed-rate payments for floating-rate payments and vice versa, which can be useful for companies with mismatched assets and liabilities.

Currency swaps involve exchanging principal and interest payments in one currency for equivalent payments in another.

For example, during the European debt crisis in 2011, Greece entered into a currency swap with Goldman Sachs, which had the effect of concealing the true extent of its debt and exacerbating the severity of the crisis when it was discovered.

Forward Contracts

Forward contracts are similar to futures but are private agreements between two parties and thus are not standardized. These contracts can be customized to fit the specific needs of the parties involved, but this customization can also introduce additional counterparty risk.

For instance, Starbucks often enters into forward contracts to purchase coffee beans at a set price in the future. This strategy allows the company to lock in costs and budget effectively, but if the supplier fails to deliver, Starbucks could face higher prices in the spot market.

Role of Derivatives in Portfolio Management

Derivatives play a crucial role in modern portfolio management. They provide avenues for hedging, speculation, and achieving arbitrage. Hedging, as mentioned earlier, involves reducing uncertainty about future price movements. Speculation, on the other hand, involves taking on risks in the hope of making a profit.

For instance, a speculator might buy a call option on a stock if they believe the stock price will rise, providing the potential for profits without the need to invest a significant amount upfront.

Arbitrage involves taking advantage of price discrepancies in different markets. Derivatives, with their inherent flexibility and the wide range of underlying assets they cover, provide numerous opportunities for arbitrage.

The Derivative Market

Derivatives Market
Source: Wallstreet Mojo

Derivatives can be traded on exchanges or over-the-counter (OTC). Exchange-traded derivatives are standardized contracts that provide transparency and reduce counterparty risk. They are typically regulated by financial authorities, adding another layer of security for participants.

OTC derivatives, however, are private contracts between parties and can be customized to meet specific requirements. While this flexibility can be beneficial, it can also increase counterparty risk, as there is no guarantee that the other party will fulfill their obligations.

Risks and Criticisms of Derivatives

Despite their utility, derivatives are not without risks and criticisms. They can magnify losses just as they can magnify profits. This leverage effect can lead to substantial losses if the market moves in the opposite direction of the derivative position.

Furthermore, the use of derivatives has been implicated in major financial crises. The 2008 financial crisis, for instance, was triggered in part by complex mortgage derivatives that many investors did not fully understand.

To mitigate these risks, regulatory bodies like the U.S. Securities and Exchange Commission (SEC) and the European Securities and Markets Authority (ESMA) have implemented measures to enhance market transparency and reduce systemic risk.

Conclusion

Derivatives play a critical role in global financial markets by facilitating price discovery, enabling risk management, and offering opportunities for returns. However, these complex financial instruments come with their own set of risks.

As such, a deep understanding of these tools is a must for anyone working in finance today. From hedging business risks to speculating on market movements, derivatives offer a wealth of possibilities for savvy professionals.

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