Derivatives are often thought of as confusing and overly complicated. Simply put, it is a financial product that derives its price from the underlying assets, which can be stocks, bonds, commodities, exchange or interest rates, market indexes, and even other derivative instruments.

The derivatives were invented as the instruments that can help to manage risk, however nowadays the use of derivatives is to modify one’s risk exposure by either increasing it or reducing it.

These sorts of contracts (or derivatives) have been around for a long time – since ancient Mesopotamia. The first example of their use was in fixing the price on certain commodities to ensure that the buyer pays a specified price on the delivery regardless any market volatility that can impact the pricing.

There are many derivative instruments that are used by both institutional and retail investors around the world, however the following four categories are the most common ones you may encounter:

• Futures and Forwards – These two instrument types are some of the most common ones and example of price-fixing above pretty much describes how these instrument work. They oblige parties to transact an underlying instrument at price specified today on particular date in the future. The main difference between them is that futures are traded as standardized contracts on centralized exchanges (such as Chicago Mercantile Exchange (CME), International Securities Exchange (ISE), Intercontinental Exchange (ICE), Euronext and many other) with publicly visible prices, while forward are traded over the counter (OTC). OTC implies that there is no centralized price, and the prices are negotiated between two parties, potentially also involving various agents and brokers.
• Swaps – This is a derivative that is agreed upon by two different parties that exchange cash flows (or liabilities) from different financial instruments that they use. They imply the exchange of the cash flows based on the features of the underlying instruments. Majority of the Swaps are linked to the interest rates or currency exchange rates and are used for hedging corporate liabilities and exposures to the foreign currencies.
• Options – These derivatives give the buyer the right (not obligation) to either buy (call options) or sell (put options) the underlying asset at an agreed upon price at a specific date in the future (for options called European) or at any point before the specified expiration date (for American options). As all derivatives, they are used for modifying the risk exposure, however many consider them to invest with high degree of leverage.

The derivatives are essential for the functioning of the modern financial markets and their emergence in the new markets is a strong indicator of the market liquidity. When we spoke about equities and bonds earlier, we have mentioned that the companies typically have very few share types (usually one) and multiple bond types, however when it comes to derivatives, their variety is trumping any other asset class and can help to modify the risk exposures in a whole range of ways.

Please note, none of the information on this blog represents the opinion of my employer and all information does not represent a financial advice.

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