Derivative (Financial)

Published Apr 7, 2024

Definition of Derivative (Financial)

A financial derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, index, or security. Common underlying instruments include bonds, commodities, currencies, interest rates, market indexes, and stocks. Derivatives can be used for a variety of purposes such as hedging (risk management), speculation (profiting from fluctuations in prices), and obtaining access to assets or markets. This financial instrument allows parties to trade specific financial risks (such as interest rate risk, currency, or commodity price risk) to the party that is better equipped to manage these risks.

Example

Imagine an airline company worried about the potential rise in fuel prices over the next year. To hedge against this risk, the company enters into a derivative contract known as a futures contract. This agreement allows the airline to purchase fuel at a predetermined price at a specified future date. If fuel prices rise beyond this predetermined price, the airline will benefit by purchasing fuel at a lower cost than the market rate. Conversely, if fuel prices fall, the airline will pay more than the market rate, but it gains the certainty of fuel costs for financial planning.

Types of Derivatives

There are several types of derivatives, including:

• Futures: Contracts to buy or sell an asset at a future date at a price specified today.
• Forwards: Similar to futures, but they are private contracts between two parties and thus, are not traded on an exchange.
• Options: Contracts that give the holder the right, but not the obligation, to buy (call option) or sell (put option) an asset at a specified price before or at a specified date.
• Swaps: Contracts to exchange cash flows between two parties at specified times in the future, based on predetermined conditions.

Why Derivatives Matter

Derivatives play a vital role in the financial markets by allowing for the efficient management of financial risk, improving market liquidity, and discovering prices for the underlying asset. Companies use derivatives to hedge against various types of risks, including fluctuations in exchange rates, interest rates, and commodity prices. Speculators and investors use derivatives to gain exposure to assets or markets without necessarily owning the underlying asset, allowing for potential profit from price movements.

Frequently Asked Questions (FAQ)

What are the risks involved in trading derivatives?

Derivatives carry several risks, including market risk, counterparty risk (the risk that the other party in the agreement will not fulfill their obligation), liquidity risk, and leverage risk. It’s critical for parties involved to understand these risks thoroughly before engaging in derivative trading.

Can derivatives be used by individual investors?

Yes, individual investors can use derivatives. However, due to the complexity and risk involved in these financial instruments, they are better suited for sophisticated investors who understand how derivatives work and are aware of the risks involved.

Are derivatives regulated?

Yes, derivatives are regulated, though the level of regulation varies by country and the type of derivative. In many countries, derivatives traded on exchanges are heavily regulated, while over-the-counter (OTC) derivatives are less so. Following the global financial crisis of 2008, there has been a push for greater regulation of OTC derivatives in particular.

How does leverage in derivatives work?

Leverage in derivatives allows traders to gain a larger exposure to the underlying asset with a relatively small amount of capital (known as the margin). While this can amplify profits, it also significantly increases the risk of losses.

In conclusion, derivatives are complex financial instruments that play a significant role in global financial markets. They offer parties the ability to manage risk or speculate but come with significant risks that must be carefully managed.