A derivative is a financial instrument whose value, pricing, and terms are based on another underlying financial instrument. Essentially, a derivative is an agreement between two parties regarding the obligation or right to transfer a specified asset at a set time and price.
Derivatives are not considered securities under the Federal Law “On the Securities Market,” except for the issuer’s option. However, there are also so-called derivative securities, such as options, forwards, futures, swaps, and more.
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Why Are Derivatives Used?
The main purpose of using derivatives is to generate speculative profit and hedge risks, both temporary and material.
Derivatives play a significant role in risk management because they allow for the separation and limitation of risks. They are used to transfer elements of risk, thus serving as a form of insurance. The probability of losses requires both parties to identify all related risks before signing the contract.
One of the key advantages of derivatives is the ability to manage risk. For example, an investor can protect their portfolio from potential losses by purchasing a put option on stocks, which would shield them from a possible drop in stock prices. If the stock price indeed falls, the value of the option increases, allowing the investor to offset losses on the stocks.
Derivatives are also used for speculative purposes, meaning to make a profit from price fluctuations in assets. For instance, a trader might buy a gold futures contract if they believe the price of gold will rise in the near future. If the prediction proves correct, the trader makes a profit.
In general, derivatives offer flexibility in investing and allow investors to access new markets and assets. However, since derivatives involve a high level of risk, investors should be cautious and fully understand their risks before investing in these instruments.
Acquiring a derivative instrument requires small initial investments, unlike its underlying instrument, so the number of such instruments available on the market often does not match the actual quantity of the underlying.
Types of Derivatives
The classification of derivative financial instruments is based on two main criteria.
By Type of Underlying Asset:
- Physical commodities: gold, oil, wheat, etc.
- Securities: stocks, bonds, bills, and more.
- Currency.
- Indices.
- Statistical data, such as key interest rates, inflation levels, etc.
By Type of Deferred Transaction:
- Forward Contract. A forward contract is an agreement where the parties agree to deliver an asset of a certain quality and quantity at a specified time. The underlying asset in forward contracts is usually a physical commodity, with its price agreed upon in advance.
- Futures Contract. A futures contract is an agreement that the transaction must take place at a specific time at the market price on the contract’s execution date. In contrast to a forward contract, where the price is fixed, the price in a futures contract can change depending on market conditions. The only requirement for futures contracts is that the goods will be sold/bought at a specific time.
- Option Contract. An option is the right, but not the obligation, to buy or sell an asset at a fixed price until a specific date. For example, if a shareholder of a company expresses a desire to sell their shares at a certain price, the interested buyer can enter into an option contract with the seller. According to the contract’s terms, the potential buyer pays the seller a certain amount of money, and the seller agrees to sell the shares to the buyer at the set price. However, the seller’s obligations remain valid only until the date specified in the contract expires. If the buyer does not complete the transaction by the specified date, the premium paid by the buyer goes to the seller, who then has the right to sell the shares to anyone.
- Swap. A swap is a dual financial transaction in which the purchase and sale of the underlying asset occur under different conditions. Essentially, a swap is a speculative tool, and the sole purpose of such actions is to gain profit from the price difference in the contracts.
How Do Derivatives Work?
Derivatives are financial instruments with several characteristics. One of them is term: the date of the deal and the settlement date can be separated in time, so trading them takes place on the futures market of the exchange.
Another attribute of a derivative is the underlying asset, which can be a security, an inflation rate, biological or chemical indicators of the environment’s condition. Moreover, the asset can even be multiple objects at once.
To better understand how a derivative works, consider an example from history described by Aristotle. Thales, an ancient Greek philosopher, predicted that there would be a high olive harvest next year. Based on this idea, he signed a contract with press owners to rent equipment for the next season and made a deposit. According to the contract, Thales had the right to use the asset – the olive press, but was not obligated to do so. If the harvest had been low, he would have lost only the deposit. However, his prediction came true, and Thales made a profit because he rented out the presses at a market price that significantly increased due to the high demand.
To determine whether a transaction qualifies as a derivative, three conditions must be considered:
- The contract must be based on an underlying asset,
- The buy/sell must occur in the future at a specified time,
- Additional investments may be required to confirm the contract – a margin deposit.
A key point in trading derivatives is their time delay. Over a long period, events can occur that are impossible to predict in advance, so transactions with derivatives are associated with higher risk.
FAQ
What is a derivative?
A derivative is a financial instrument whose value is based on an underlying asset, such as stocks, commodities, or currencies.
What are the main types of derivatives?
The main types include futures, options, forwards, and swaps, each serving different purposes in trading and risk management.
Why are derivatives used?
Derivatives are used for speculation, hedging against risks, and gaining exposure to different markets and assets without directly owning the underlying asset.
