What are Derivatives?
Derivatives are financial contracts whose value is linked to the value of an underlying asset. They are complex financial instruments that are used for various purposes, including hedging and getting access to additional assets or markets.
Most derivatives are traded over-the-counter (OTC). However, some of the contracts, including options and futures, are traded on specialized exchanges. The biggest derivative exchanges include the CME Group (Chicago Mercantile Exchange and Chicago Board of Trade), the Korea Exchange, and Eurex.
History of the Market
Derivatives are not new financial instruments. For example, the emergence of the first futures contracts can be traced back to the second millennium BC in Mesopotamia. However, the financial instrument was not widely used until the 1970s. The introduction of new valuation techniques sparked the rapid development of the derivatives market. Nowadays, we cannot imagine modern finance without derivatives.
Types of Derivatives
1. Forwards and futures
These are financial contracts that obligate the contracts’ buyers to purchase an asset at a pre-agreed price on a specified future date. Both forwards and futures are essentially the same in their nature. However, forwards are more flexible contracts because the parties can customize the underlying commodity as well as the quantity of the commodity and the date of the transaction. On the other hand, futures are standardized contracts that are traded on the exchanges.
Options provide the buyer of the contracts the right, but not the obligation, to purchase or sell the underlying asset at a predetermined price. Based on the option type, the buyer can exercise the option on the maturity date (European options) or on any date before the maturity (American options).
Swaps are derivative contracts that allow the exchange of cash flows between two parties. The swaps usually involve the exchange of a fixed cash flow for a floating cash flow. The most popular types of swaps are interest rate swaps, commodity swaps, and currency swaps.
Advantages of Derivatives
Unsurprisingly, derivatives exert a significant impact on modern finance because they provide numerous advantages to the financial markets:
1. Hedging risk exposure
Since the value of the derivatives is linked to the value of the underlying asset, the contracts are primarily used for hedging risks. For example, an investor may purchase a derivative contract whose value moves in the opposite direction to the value of an asset the investor owns. In this way, profits in the derivative contract may offset losses in the underlying asset.
2. Underlying asset price determination
Derivates are frequently used to determine the price of the underlying asset. For example, the spot prices of the futures can serve as an approximation of a commodity price.
3. Market efficiency
It is considered that derivatives increase the efficiency of financial markets. By using derivative contracts, one can replicate the payoff of the assets. Therefore, the prices of the underlying asset and the associated derivative tend to be in equilibrium to avoid arbitrage opportunities.
4. Access to unavailable assets or markets
Derivatives can help organizations get access to otherwise unavailable assets or markets. By employing interest rate swaps, a company may obtain a more favorable interest rate relative to interest rates available from direct borrowing.
Disadvantages of Derivatives
Despite the benefits that derivatives bring to the financial markets, the financial instruments come with some significant drawbacks. The drawbacks resulted in disastrous consequences during the financial crisis of 2007-2008. The rapid devaluation of mortgage-backed securities and credit-default swaps led to the collapse of financial institutions and securities around the world.
1. High risk
The high volatility of derivatives exposes them to potentially huge losses. The sophisticated design of the contracts makes the valuation extremely complicated or even impossible. Thus, they bear a high inherent risk.
2. Speculative features
Derivatives are widely regarded as a tool of speculation. Due to the extremely risky nature of derivatives and their unpredictable behavior, unreasonable speculation may lead to huge losses.
3. Counter-party risk
Although derivatives traded on the exchanges generally go through a thorough due diligence process, some of the contracts traded over-the-counter do not include a benchmark for due diligence. Thus, there is a possibility of counter-party default.
We hope you enjoyed reading CFI’s explanation of derivatives. CFI is the official provider of the Financial Modeling & Valuation Analyst (FMVA)™ designation for financial analysts. From here, we recommend continuing to build out your knowledge and understanding of more corporate finance topics such as: