LeoGlossary: Derivative

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A financial instrument which has value based upon a traditional security such as stocks or bonds, or an asset such as a commodity or index. It is a contract that derives its value from an underlying asset. This can also be based upon an interest rate or an index.

Purposes:

  • a hedge against price movements
  • a way to leverage up on a trade
  • an entry into hard to penetrate markets or acquiring assets that are scarce

Common Examples:

Derivatives usually trade over-the-counter or on an exchange such as the Chicago Mercantile Exchange.

There are three categories of financial instruments:

This is a contract between two parties that spells out specific terms which payments are to be made. It usually covers the dates, resulting values and definitions of the underlying variables, the parties' contractual obligations, and the notional amount.

In addition to using the assets mentioned above as the underlying value, derivatives can be created on top of other derivatives. This naturally adds another layer of complexity to the valuation models.

The key to derivatives is the underlying asset does not have to be acquired. Thus, we see a separation of ownership and market access. Those who are speculating will often buy a derivative as a way to get involved in the price movements without having to spring for the asset itself. Derivatives are usually sold at a lower price while also offering some form of leverage.

Risk, especially as it applies to the underlying asset has to be built into the framework of the derivative. They do provide a great deal of flexibility allowing them to accelerate the impact of a price move (leverage), decelerate it (hedge) or work in reverse (puts are an example of this).

There are two types of contracts:

  • Locked - where the parties agree to some type of transaction (swap, future, forward) and it is stated in the contract.

  • Option - where one party has the choice of whether to accept the terms. Here the buyer has the right but not the obligation to follow through. This is common with commodities where there is the option to take delivery.

Derivatives are concerned about the price movement of the underlying asset. There is no value in the derivative itself. The correlation is to the value of the underlying and where it goes. In both hedging and speculation, each party has a concern about the future price movements. Depending upon which side of the trade they are on tells where they stand regarding risk. One party is unloading it while the other is taking it on.

Types

Over-the-Counter (OTC)

Contracts that are negotiated between two parties directly. They do not go through an exchange or any other type of intermediary.

Swaps, forward rate agreements and other exotic derivatives are all traded this way. It is a market that is mostly unregulated. The main parties are banks and other financial institutions such as hedge funds. Since most of the transactions are completely private, it is hard to know the size of the market. The amounts of the trades are largely unknown.

Due to the direct nature of these trades, there is no central counter-party. Hence, each trade involved counter-party risk.

Exchange Traded Derivatives (ETDs)

These are derivatives that are traded on specially designed exchanges. They map out the standard size of the trade and offer many of the services that are available with other asset classes. The exchange acts as the intermediary on all transactions, taking initial margin from all parties.

The largest derivative exchanges are:

Hedging

One of the biggest use cases for options is to hedge. This allows for risk to be spread to another party.

Commodity futures (or forward) are often used by corporations who use the underlying product as a part of the business. For example, an airline or trucking company might enter a contract to buy fuel at a particular price, insulating itself against any increases that might take place.

The reverse is also true. A farmer of a commodity such as wheat or soybeans will enter a similar contract agreeing to sell the product at a particular price. In this instance, the goal is to prevent realizing a loss if the bottom falls out of the market.

Another way to hedge is to buy an asset and immediately sell a contract that specifies terms and conditions to the transference in the future. This allows the individual or institution to hold the asset, enjoying things such as stream of payments, while also reducing risk associated with a drop in the value of the asset.

Speculation

This is the opposite of hedging. Here is where derivatives are used to acquire risk. The entity that buys the derivative has an appetite to take on more, hoping to leverage its returns.

The key here is the individual or institution is speculating on the price of the underlying asset. A conclusion was reached about the direction of the price going forward. This is what is being bet upon.

Essentially, the speculator is looking to get an asset at a low future price when it will be trading high or selling for a high future price when it is low. This is where the speculation comes in on the part of the buyer.

Inverse Price Moves

Another major use case for derivatives is to decouple from the direction of the price move of the underlying asset. In this instance, as the price of the asset goes down, the derivative will go up. The reserve is also true. An example of this is the put option. As the price of the underlying stock declines, the value of the put, depending upon the time element, will appreciate.

We see inverse Exchange Traded Funds (ETFs) that look to fill this role. These can be traded on the major exchanges.

General:

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