Subject: Derivatives - Basics

Last-Revised: 8 Apr 2009
Contributed-By: Brian Hird (bmhird.investfaq at googlemail.com), Chris Lott (contact me)

A derivative is a contract with financial performance that is derived from the performance of something else. That "something else" is an underlying asset commonly termed "the underlying" and may be another financial instrument, another derivative, or an index of some kind. An example is a call option on a stock, in which the option is the derivative and the stock is the underlying asset (also see the FAQ article on stock option basics).

How are derivatives used?

A commonly used example is a grain (i.e., commodity) future. The contract is the derivative, and the underlying asset is the edible grain such as wheat or corn. A farmer who grows grains can enter into a contract that is an obligation to sell the grain at a fixed price at a date in the future. An investor takes the other side of the contract agreeing to buy the grain at that fixed price for delivery on that future date. The farmer obtains a guarantee he will be able to sell his grain for the agreed price, thus eliminating the risk of the price falling between now and when the crop is ready for delivery. If the grain price falls sharply, the farmer still receives the payment specified in the contract, and the investor loses money. If the grain price rises sharply, again the farmer receives the payment specified in the contract, and the investor may make a profit by reselling the grain at the current, higher price. Although it is crucial that a mechanism for delivery or settlement exists to tie the futures contract price to "the underlying", it is important to note that for most futures only a small fraction of the contracts traded are actually delivered or settled. Most positions are closed before the delivery or settlement date.

How are derivatives traded?

To reduce the risk of default by either party to a contract, an exchange-traded derivatives contract usually goes through a clearing process whereby a clearinghouse becomes the counterparty to each of the traders rather than each other. The clearinghouse is well capitalized and has rules regarding collateral that must be posted by each trader reflecting the financial performance of that trader's contracts so as to minimize the risk of losses by the clearinghouse. These measures minimize the possibility of a clearinghouse defaulting.

Exchange Traded derivatives are standardized contracts. Standardization should improve liquidity but obviously comes at the expense of the ability to customize a transaction to an individual trader's requirements. Trading in OTC derivatives is generally only available to professional investors in the wholesale market. Banks, fund managers, pension funds, insurance companies and hedge funds are active users of the OTC derivatives market.

What are some types of derivatives?

Swap contracts are agreements to exchange one asset or liability for another. The asset or liability is usually a future payment or stream of payments. If it is a foreign currency swap this may entail buying a currency on the spot market and simultaneously selling it forward. If it is an interest rate swap this may involve exchanging income flows; for example, exchanging a stream of fixed rate payments (such as those received from a fixed rate bond) for a variable rate payment stream.

Options are the right but importantly not the obligation to enter into a pre-arranged financial agreement at a pre-defined price on a future date or dates. As with futures and forwards, options may be traced either on exchanges or OTC. There may be conditions that must be fulfilled before the right to enter in to the agreement is conferred. Credit default swaps (which are typically traded OTC) are a good example of this.

In general, futures, forwards and swaps have payoff profiles that are approximately linear functions of the performance of the underlying. In derivatives-speak they are said to have approximately constant delta, delta being the change in value of the derivative contract for the change in the price of the underlying instrument. Options, however, will have a payoff profile that is a non-linear function of the value of the underlying instrument. This can make option trading much more complex than trading approximately linear derivatives.

For what types of underlying markets are derivatives traded?

• Spot foreign exchange. This is the buying and selling of foreign currency at the exchange rates that you see quoted on the news. As these rates change relative to your "home currency" (dollars if you are in the US) you make or lose money.
• Commodities, like grain discussed in the example above. Others include pork bellies, coffee beans, orange juice, gold, silver, and crude oil.
• Equities (termed stocks in the US).
• Government bonds. Bonds are medium to long-term negotiable debt securities issued by national governments. They may generally be freely traded without reference to the issuer of the security, unlike loans.
• Short term ("money market") negotiable debt securities such as Treasury Bills (issued by governments), Commercial Paper (issued by companies) or Bankers Acceptances. These are much like bonds, differing mainly in their maturity - always less than one year, and typically less than 90 days.
• OTC money market indexes - typically LIBOR (the London Interbank Offered Rate) or some other similar index of the rates at which banks are willing to enter OTC lending transactions with each other.
• Credit risk - a credit default swap (CDS), despite its name, is actually more like an option or insurance contract. In exchange for a stream of premium payments the buyer of a vanilla (or "single issuer") CDS obtains the right to require the CDS seller to purchase bonds of the issuer named in the agreement at a given price (usually the face value) but only if the named issuer triggers a default or other similar "credit event". The market price of these bonds is typically much less than face value when a default occurs so the CDS buyer will profit and the CDS seller will lose. If the named issuer does not default during the agreed period of the CDS the contract expires worthless, just as an option would if it was not worth exercising.
• Indexes - many index varieties are used as the underlying for derivative contracts. They may be constructed with reference to financial assets (such as stock market indexes like the Dow Jones Industrial Average) or even to temperature or rainfall (in the case of weather derivatives).

This FAQ offers many articles about futures and options. Please see those sections.

Derivatives, risk-taking and regulation

Some hedging (risk reduction) with derivatives is done by offsetting an existing position with a related derivative that is strongly correlated with the position to be hedged. An example is selling a stock index future to protect against a loss in a generalized (non sector specific) stock portfolio. Although the stock portfolio may contain a different mix of stocks than the stock index, typically we would still expect the index future to move in roughly the same fashion as the portfolio. The risk that the value of the derivatives position does not move in exactly the same way as that of the stock portfolio is termed "basis risk". There is significant basis risk when the correlation between the derivatives hedge and the risky position is weak, or breaks down in a crisis - exactly when effective hedging is needed most. Potentially big losses (or if the investor is lucky, profit) can ensue.

However it is easy for a bank to take accidentally take on too much basis risk. And of course although banks may be using derivatives to hedge (reduce) risk, they may also be using them as a way of increasing risk to make money. Taking on risk is how a bank makes money; for example, issuing loans is a risk.

As of this update (2009), derivatives are being blamed for many of the financial losses suffered by banks and other financial institutions around the world. Many banks took on so much risk (bought assets that suffered losses) that they collapsed, and taxpayers around the world are being forced to pay huge sums so financial markets keep functioning. New regulations are promised so that use of derivatives is more transparent.

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