Derivatives are a type of financial contract whose value is derived from an underlying asset, group of assets, or benchmark. These securitized agreements involve two or more parties and can be traded on exchanges or over-the-counter (OTC). Their prices fluctuate based on movements in the underlying asset.
At their core, derivatives allow investors to gain exposure to certain markets or trade specific assets without directly owning them. They can be used for hedging to mitigate risk, or for speculative purposes with the potential for higher rewards. Derivatives essentially transfer risk from risk-averse parties to those seeking risk.
Derivatives come in many shapes and sizes, providing exposure to stocks, bonds, commodities, currencies, interest rates, market indexes and more. Common forms include futures, forwards, swaps, and options.
Futures contracts obligate the buyer to purchase an asset, and the seller to sell an asset, at a predetermined future date and price. Options give the buyer the right, but not obligation, to buy or sell the underlying asset at a set price before expiration.
Forwards are similar to futures but traded OTC with customized terms. Swaps involve exchanging one cash flow for another, such as switching from a variable to fixed interest rate.
Many derivatives are leveraged instruments, meaning only a small amount of capital is required to gain exposure to a larger value of the underlying asset. This leverage amplifies potential profits but also magnifies potential losses.
OTC derivatives carry higher counterparty risk since they are unregulated private contracts. One party could default on their obligations. Exchange-traded derivatives are more standardized and regulated.
Derivatives can be complex, making them difficult to value precisely. Their sensitivity to time, interest rates, and market sentiment adds further uncertainty around pricing.
When used responsibly, derivatives provide a versatile risk management tool for hedging and a means for investors to gain exposure without outright ownership. However, their complexity, leverage, and lack of inherent value demands caution. As with any investment, it's crucial to understand the risks fully before trading derivatives.
While derivatives have become increasingly complex financial instruments in modern times, their origins can be traced back centuries. One of the earliest examples is the tulip mania futures contracts traded in the Dutch Republic during the 1600s.
Derivatives really began taking their current form in the mid-19th century. This is when futures contracts were introduced to help farmers and merchants lock in prices and mitigate risk around the future delivery of agricultural commodities.
The Chicago Board of Trade (CBOT), established in 1848, was a pioneer in listed derivative trading. It facilitated the transfer of risk associated with guaranteeing the future delivery of grains. This allowed farmers to hedge against price drops and merchants to hedge against price increases before taking delivery.
The derivatives market continued evolving throughout the 20th century. Equity options were introduced in 1973. Currency futures emerged in the 1970s as well after the collapse of the Bretton Woods fixed exchange rate system.
Interest rate and equity index futures came about in the 1970s and 1980s. The growth of the over-the-counter (OTC) derivatives market took off in the 1980s with the introduction of interest rate and currency swaps.
Today, derivatives are an integral part of modern finance. The total notional value of outstanding derivatives contracts exceeded $600 trillion globally as of 2021 according to the Bank for International Settlements.
While derivatives get a bad rap from the general public, in part due to the role they played in the 2008 financial crisis, they can be effectively utilized when proper risk controls are in place. Here are some common strategies:
Hedging: Derivatives can be used to reduce or offset risk of price movements in the underlying asset. A producer of oil could short futures contracts to lock in prices, protecting against a drop in oil prices reducing revenue.
Speculation: The leverage provided by derivatives allows traders to speculate on the future direction of assets or rates with limited upfront capital.
Arbitrage: Discrepancies in pricing between derivatives and their underlying assets present arbitrage opportunities to capture risk-free profits.
No matter the strategy, having an understanding of derivatives pricing models, implied volatility, time decay, and other important concepts is crucial. Prudent risk management through stop losses and diversification is also essential given the leverage involved.
The derivatives market continues rapidly evolving with new exotic products constantly emerging. While powerful instruments when used correctly, their complexity means derivatives should only be invested in by those willing to learn and manage the risks diligently.