A derivative is afinancial contract that derives its value from anunderlying asset. Thebuyer agrees to purchasethe asset on a specific date at a specific price.
Derivatives are often used forcommodities, such as oil, gasoline, or gold. Another asset class is currencies, often theU.S. dollar.There are derivatives based onstocksor bonds. Others useinterest rates, such as the yield on the10-year Treasury note.
The contract's seller doesn't have to own the underlying asset. They can fulfill the contract by giving the buyer enough money to buy the asset at the prevailing price. They can also give the buyer another derivative contract that offsetsthe value of the first.This makes derivatives much easier to trade than the asset itself.
Derivatives Trading
In 2019, 32 billion derivative contracts were traded.Most of the world's 500 largest companies use derivativesto lower risk. For example, afutures contract promises the delivery of raw materials at an agreed-upon price. This way, the company is protected if prices rise. Companies also write contracts to protect themselves from changes inexchange ratesand interest rates.
Derivatives make future cash flows more predictable. They allow companies toforecast their earnings more accurately. That predictability boosts stock prices, and businesses then need a lower amount of cash on hand to cover emergencies. That means they can reinvest more into their business.
Most derivatives trading is done byhedge fundsand other investors to gain moreleverage. Derivatives only require a small down payment, called “paying on margin.”
Many derivatives contracts are offset—or liquidated—by another derivative before coming to term. These traders don't worry about having enough money to pay off the derivative if the market goes against them.If they win, they cash in.
Note
Derivatives that are traded between two companies or traders that know each other personally are called“over-the-counter” options. They are also traded through an intermediary, usually a large bank.
Exchanges
A small percentage of the world's derivatives are traded on exchanges. These public exchanges set standardized contract terms. Theyspecify the premiums or discounts on the contract price. This standardization improves the liquidity of derivatives. It makesthem more or less exchangeable, thus making them more useful forhedging.
Exchanges can also be a clearinghouse, acting as the actual buyer or seller of the derivative. That makes it safer for traders since they know the contract will be fulfilled. In 2010, theDodd-Frank Wall Street Reform Actwas signed in response to the financial crisis and to prevent excessive risk-taking.
The largest exchange is theCME Group, which is the merger of the Chicago Board of Trade and the Chicago Mercantile Exchange, also called CME orthe Merc.It trades derivatives in all asset classes.
Stock optionsare traded on theNASDAQor the Chicago Board Options Exchange. Futures contracts are traded on the Intercontinental Exchange, which acquired the New York Board of Trade in 2007. It focuses on financial contracts, especially on currency, and agricultural contracts, principally dealing with coffee and cotton.
The Commodity Futures Trading Commission or theSecurities and Exchange Commission regulates these exchanges. Trading Organizations,Clearing Organizations,andSEC Self-Regulating Organizations have a list of exchanges.
Types of Financial Derivatives
The most notorious derivatives arecollateralized debt obligations. CDOs werea primary cause of the2008 financial crisis. These bundle debt, such as auto loans,credit card debt,or mortgages, into a security that is valued based on the promised repayment of the loans.
There are two major types:Asset-backed commercial paperis based on corporate and business debt.Mortgage-backed securitiesare based on mortgages. When thehousing marketcollapsed in 2006, so did the value of the MBS and then the ABCP.
The most common type of derivative is a swap. This is an agreement to exchange one asset or debt for a similar one. The purpose is to lower risk for both parties. Most of them are either currency swaps orinterest rate swaps.
For example, a trader might sell stock in the United States and buy it in a foreign currency to hedgecurrency risk. These are OTC, so these are not traded on an exchange. A company might swap the fixed-rate coupon stream of a bond for a variable-rate payment stream of another company's bond.
The most infamous of these swaps werecredit default swaps. They also helped cause the 2008 financial crisis. They were sold to insure against the default of municipal bonds, corporate debt, ormortgage-backed securities.
When the MBS market collapsed, there wasn't enoughcapitalto pay off the CDS holders. The federal government had to nationalize theAmerican International Group. Thanks to Dodd-Frank, swaps are now regulated by the CFTC.
Forwardsare another OTC derivative. They are agreements to buy or sell an asset at an agreed-upon price at a specific date in the future. The two parties can customize their forward a lot. Forwards are used to hedgerisk in commodities, interest rates,exchange rates,or equities.
Another influential type of derivative is afutures contract. The most widely used arecommodities futures. Of these, the most important areoil pricefutures—which set the price of oil and, ultimately, gasoline.
Another type of derivative simply gives the buyer the option to either buy or sell the asset at a certain price and date.
Note
The most widely used areoptions. The right to buy is acall option, and the right to sell a stock is aput option.
Four Risks of Derivatives
Derivatives have four large risks. The most dangerous is that it's almost impossible to know any derivative's real value. It's based on the value of one or more underlying assets. Their complexity makes them difficult to price.
That's the reason mortgage-backed securitieswere so deadly to the economy. No one, not even the computer programmers who created them, knew what their price was when housing prices dropped. Banks had become unwilling to trade them because they couldn't value them.
Another risk is also one of the things that makes them so attractive:leverage. For example, futures traders are only required to put 2% to 10%of the contract into a margin account to maintain ownership. If the value of the underlying asset drops, they must add money to the margin account to maintain that percentage until the contract expires or is offset.
If the commodity price keeps dropping, covering the margin account can lead to enormous losses. TheCFTC Education Centerprovides a lot of information about derivatives.
The third risk is their time restriction. It's one thing to bet that gas prices will go up. It's another thing entirely to try to predict exactly when that will happen. No one who bought MBS thought housing prices would drop. The last time they did was during theGreat Depression. They also thought they were protected by CDS.
The leverage involved meant that when losses occurred, they were magnified throughout the entire economy. Furthermore, they were unregulated and not sold on exchanges. That’s a risk unique to OTC derivatives.
Last but not least is the potential for scams. Bernie Madoffbuilt hisPonzi schemeon derivatives. Fraud is rampant in the derivatives market. TheCFTC advisory lists the latest scams in commodities futures.
Frequently Asked Questions (FAQs)
What are crypto derivatives?
Crypto derivatives offer a way to speculate or hedge cryptocurrency exposure. These derivatives include bitcoin futures traded alongside equities and commodities with the CME Group. There is also an ETF that contains bitcoin futures (BITO), and traders can trade options on BITO as another type of crypto derivative.
However, crypto derivatives can also refer to specialized futures that trade on crypto exchanges like BitMEX. These products are similar to standard futures, but they are highly leveraged, and there are differences in how traders' positions are liquidated.
What are the types of stock derivatives?
Stock options—calls and puts—are perhaps the best-known stock derivatives, but they aren't the only types. Other types of derivatives, like swaps and forwards, are also sometimes issued for a stock. While it isn't technically a derivative of a single stock, traders can use futures like ES and NQ as derivatives of the broader stock market.
