LeoGlossary: Derivative

Different Uses of the Word "Derivative"

The word "derivative" has several distinct meanings and uses across various fields:

Linguistics: A derivative is a word that is formed from another word, usually by adding an affix. For example, the word "childish" is a derivative of the word "child".
Chemistry: A derivative is a chemical compound that is structurally related to another compound, often formed by substituting or adding functional groups. For example, chloroform is a derivative of methane.
Mathematics: In mathematics, a derivative refers to the rate of change of a function with respect to its input variable. It represents the instantaneous slope or gradient of the function at a given point. Derivatives are fundamental to calculus and have many applications, such as optimization, approximation, and analyzing rates of change.
Finance: In finance, a derivative is a financial instrument whose value is derived from the value of an underlying asset, such as a stock, bond, commodity, or currency. Examples include options, futures, and swaps. Derivatives are used to manage risk or speculate on price movements.
General Usage: More broadly, a derivative can refer to something that is developed or obtained from something else, such as a by-product, spin-off, or offshoot. This usage is often used in a disapproving way to describe something as not being original or innovative.

Finance

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:

forward
options
swaps
futures

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

There are three categories of financial instruments:

equity - stocks
debt - bonds and mortgages
derivatives

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.

History

The history of financial derivatives can be traced back to ancient times, but the modern derivatives market has its roots in the commodities markets of the 19th century. The first modern financial derivatives were created in the mid-19th century, when traders on the Chicago Board of Trade (CBOT) began using futures contracts to hedge against price fluctuations in agricultural commodities, such as wheat and corn. These futures contracts allowed farmers and merchants to lock in prices for their crops and reduce their risk exposure.

Futures contracts are a type of financial derivative that is a legal agreement to buy or sell a particular commodity or financial instrument at a predetermined price at a specified time in the future. The buyer of a futures contract is taking on the obligation to buy and receive the underlying commodity or financial instrument when the futures contract expires, while the seller is obligated to provide the underlying commodity or financial instrument when the futures contract expires.

In the early 20th century, financial derivatives began to be used in the stock market. In 1919, the Chicago Butter and Egg Board, which later became the Chicago Mercantile Exchange (CME), introduced the first stock index futures contract, which was based on the Dow Jones Industrial Average. A stock index futures contract is a financial derivative that is based on the value of a stock market index, such as the Dow Jones Industrial Average or the S&P 500. These contracts allow investors to speculate on the direction of the stock market as a whole, rather than on individual stocks.

The use of financial derivatives expanded rapidly in the post-World War II era, as financial markets became more globalized and interconnected. In the 1970s and 1980s, new types of derivatives, such as options and swaps, were introduced, and the market for these instruments grew rapidly. An option is a financial derivative that gives the holder the right, but not the obligation, to buy or sell a particular asset at a predetermined price at a specified time in the future. A swap is a financial derivative in which two parties agree to exchange financial instruments or cash flows at set dates in the future.

The use of financial derivatives became even more widespread in the 1990s and 2000s, as financial institutions and investors sought to manage their risk exposure and take advantage of new investment opportunities. However, the use of derivatives was also a major factor in the financial crisis of 2008. Complex financial instruments, such as mortgage-backed securities and credit default swaps, contributed to the collapse of several major financial institutions. A mortgage-backed security is a type of asset-backed security that is secured by a collection of mortgages. A credit default swap is a financial derivative that allows an investor to "swap" or transfer the credit risk of a bond or a portfolio of bonds to another party.

In the wake of the financial crisis, there have been efforts to reform the derivatives market and increase transparency and oversight. The Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in 2010, established new regulations for the derivatives market, including mandatory clearing and reporting requirements for certain types of derivatives. However, the use of financial derivatives remains a key part of the global financial system, and is expected to continue to play an important role in managing risk and facilitating investment.

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:

Korea Exchange
Eurex
CME Group

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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