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What is a 'Derivative'

A derivative is a financial security with a value that is reliant upon, or derived from, an underlying asset or group of assets. The derivative itself is a contract between two or more parties, and its price is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.

Derivatives can either be traded over-the-counter (OTC) or on an exchange. OTC derivatives constitute the greater proportion of derivatives and are not standardized. Meanwhile, derivatives traded on exchanges are standardized and more heavily regulated. OTC derivatives generally have greater counterparty risk than standardized derivatives.

BREAKING DOWN 'Derivative'

Originally, derivatives were used to ensure balanced exchange rates for goods traded internationally. With differing values of national currencies, international traders needed a system to account for these differences. Today, derivatives are based upon a wide variety of transactions and have many more uses. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a region.

There are many different types of derivatives that can be used for risk management or for speculation. For example, imagine a European investor who purchases shares of a U.S. company through a U.S. exchange using U.S. dollars. This investor is exposed to exchange-rate risk while holding that stock. If the value of the euro rises relative to the dollar, the investor's profits in dollar terms are less valuable when those profits are converted back into euro once the stock is sold. To hedge this risk, the investor could purchase a currency derivative to lock in a specific exchange rate. Derivatives that could be used to hedge this kind of risk include futures and currency swaps.

A speculator who expects the euro to appreciate compared to the dollar could profit by using a derivative that rises in value with the euro. When using derivatives to speculate on the price movement of an underlying asset, the investor does not need to have an interest in the underlying asset.

Many derivative instruments are leveraged. That means a small amount of capital is required to have an interest in a large amount of value in the underlying asset. For example, an investor who expects the S&P 500 stock index to rise in value could buy a futures contract based on that asset. The notional value of a futures contract on the S&P 500 is $250,000, but the Chicago Mercantile Exchange (CME) only required $30,000 in a margin balance to maintain a long position in the derivative in 2018. This gives the futures investor a leverage ratio greater than 8:1. The required margin to hold a futures or derivative position changes depending on market conditions and broker requirements.

Common Forms of 'Derivative'

Futures

Futures contracts are one of the most common types of derivatives. A futures contract (or simply, futures) is an agreement between two parties for the purchase and delivery of an asset at an agreed upon price at a future date. Futures are exchange traded, and the contracts are standardized. Traders will use a futures contract to hedge their risk or speculate on the price of an underlying asset.

For example, on Nov. 6, Company-A buys a futures contract for oil at a price of $62.22 per barrel that expires on Dec. 19, 2018. The company wants to do this because it needs oil in December and is concerned that the price will rise before the company actually needs to make the purchase. Buying an oil futures contract hedges the company's risk because the seller on the other side of the contract is obligated to deliver oil to Company-A for $62.22 per barrel once the contract has expired. Assume oil prices rise to $80 per barrel by Dec. 19, 2018. Company-A can accept delivery of the oil from the seller of the futures contract, but if it no longer needs the oil, it can also sell the contract before expiration and keep the profits.

In this example, it is possible that both the futures buyer and seller were hedging risk. Company-A needed oil in the future and wanted to offset the risk that the price may rise in December with a long position in an oil futures contract. The seller could be an oil company that was concerned about falling oil prices and wanted to eliminate that risk by selling or "shorting" a futures contract that fixed the price it would get in December.

It is also possible that the seller or buyer (or both) of the oil futures contract were speculators with the opposite opinion about the direction of oil in November and December. If the parties involved in the futures contract were speculators, it is unlikely that either of them would want to make arrangements for delivery or shipment of crude oil. Speculators can end their obligation to purchase or deliver the underlying commodity by closing their contract before expiration.

The futures contract for West Texas Intermediate (WTI) oil that trades on the CME represents 1,000 barrels of oil. In this example, if the price of oil rose from $62.22 to $80 per barrel, the trader with the long position (buyer) in the futures contract would have profited $17,780 [($80 - $62.22) X 1,000 = $17,780], and the trader with the short position (seller) in the contract would have lost $17,780.

Not all futures contracts are settled at expiration by delivering the underlying asset. Many derivatives are cash-settled, which means that the gain or loss in the trade is a positive or negative cash flow to the trader. Futures contracts that are cash settled include many interest rate futures, stock index futures, and more unusual instruments like volatility futures or weather futures.

Forwards

Forward contracts are an important kind of derivative similar to futures. Unlike futures, forward contracts (or "forwards") are not traded on an exchange, only over-the-counter. When a forward contract is created, the buyer and seller may have customized the terms, size and settlement process for the derivative. The buyers and sellers of forward contracts also have counterparty risks.

Counterparty risks are a kind of credit risk in that the buyer or seller may not be able to live up to the obligations outlined in the contract. If one party of the contract becomes insolvent, the other party may have no recourse and could lose the value of its position. Once created, the parties in a forward contract can offset their position with other counterparties, which can increase the potential for counterparty risks as more traders become involved in the same contract.

Swap

Swaps are another common type of derivative that is often used to swap one kind of cash flow with another. For example, one might use an interest rate swap to switch from a variable interest rate loan to a fixed interest rate loan, or vice versa.

Imagine that InvestCo, Inc. has borrowed $1,000,000 and pays a variable rate of interest on the loan that is currently 6%. InvestCo may be concerned about rising interest rates that will increase the costs of this loan or encounter a lender that is reluctant to extend more credit while InvestCo has this variable rate risk.

Assume that InvestCo creates a swap with FixedCo, Inc., which is willing to exchange the payments owed on the variable rate loan for the payments owed on a fixed rate loan of 7%. That means that InvestCo will pay 7% to FixedCo on $1,000,000 principal, and FixedCo will pay InvestCo 6% interest on the same principal. At the beginning of the swap, InvestCo will just pay FixedCo the 1% difference between the two swap rates.

If interest rates fall so that the variable rate on the original loan is now 5%, InvestCo will have to pay FixedCo the 2% difference on the loan. If interest rates rose to 8%, then FixedCo would have to pay InvestCo the 1% difference between the two swap rates. Regardless of how interest rates change, the swap has achieved InvestCo's original objective of turning a variable rate loan into a fixed rate loan.

Swaps can also be constructed to exchange the risk of default on a loan or cash flows from other business activities. Swaps related to the cash flows and potential defaults of mortgage bonds are an extremely popular kind of derivative. The counterparty risk of swaps like this eventually spiraled into the credit crisis of 2008.

Options

Options are another common form of derivative. An option is similar to a futures contract in that it is an agreement between two parties to buy or sell an asset at a predetermined future date for a specific price. The key difference between options and futures is that, with an option, the buyer is not obligated to "exercise" the option, while the option seller is obligated to either buy or sell the underlying asset if the buyer chooses to exercise the contract. As with futures, options may be used to hedge or speculate on the price of the underlying asset.

Imagine an investor owns 100 shares of a stock worth $50 per share that she believes will rise in value in the future. However, this investor is concerned about potential risks and decides to hedge her position with an option. The investor could buy a put option that gives her the right to sell 100 shares of stock for $50 per share (strike price) until a specific day in the future (expiration date).

Assume that the stock falls in value to $40 per share by expiration and the put option buyer decides to exercise her option and sell the stock for the original strike price of $50 per share. If the put option cost the investor $200 to purchase, then she has only lost the cost of the option ($200) because the strike price was equal to the price of the stock when she originally bought the put option. A strategy like this is called a "protective put" because it hedges the stock's downside risk.

Alternatively, assume an investor does not own the stock that is currently worth $50 per share; however, he believes that the stock will rise in value over the next month. This investor could buy a call option that gives him the right to buy the stock for $50 before or at expiration. Assume that this call option cost $200 and the stock rose to $60 before expiration. The call buyer can now exercise his option and buy a stock worth $60 per share for the $50 strike price, which is an initial profit of $10 per share. A call option represents 100 shares, so the real profit is $1,000 less the cost of the option for a net profit of $800.

In both examples, the put and call sellers are obligated to fulfill their side of the contract if the call or put option buyer chooses to exercise the contract. However, if a stock's price is above the strike price at expiration, the put will be worthless and the seller gets to keep the premium as the option expires. If the stock's price is below the strike price at expiration, the call will be worthless and the call seller will keep the premium. Some options can be exercised before expiration (so-called "American-style" options), but early exercise is rare.

Limitations of Derivatives

Derivatives are difficult to value because they are based on the price of another asset. The risks for OTC derivatives include counterparty risks that are difficult to predict or value as well. Most derivatives are also sensitive to changes in the amount of time to expiration, the cost of holding the underlying asset and interest rates. These variables make it difficult to perfectly match the value of a derivative with the underlying asset. For example, it is possible for the supply and demand of a derivative to cause it to rise and fall in value regardless of what is happening with the price of the underlying asset.

Derivatives Summary

Derivatives are a security that derive their value from an underlying asset or benchmark. Common derivatives include futures contracts, options and swaps. Most derivatives are not traded on exchanges and are used by institutions to hedge risk or speculate on price changes in the underlying asset. Exchange-traded derivatives like futures and stock options are standardized and eliminate or reduce many of the risks of over-the-counter derivatives like counterparty and liquidity risks. Derivatives are usually leveraged instruments, which increases the potential risks and rewards of these securities.

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