According to the US National Bureau of Economic Research, the derivatives market has grown 100-fold over the past 30 years and is currently estimated at more than USD 200 trillion. The reality is that derivatives are almost omnipresent on financial markets – used everywhere from mutual funds and pension plans to insurance policies and government bonds.
But what’s hard for many of us to get our heads around is that most of this value isn’t connected to anything physical or easy to picture in our minds, such as gold, a listed company or even a cryptocurrency. That’s because a derivative is any investment that ‘derives’ its value from another investment – typically from an underlying asset such as a stock, a bond, interest rates, a commodity, an index, or even a basket of cryptocurrencies. Essentially, derivatives exist only on paper.
Four main participants in the derivatives market:
1. Hedgers
Hedgers use derivatives to reduce risk or future exposure. Examples include farmers selling cattle futures to reduce price uncertainty or bond issuers using interest rate swaps to match future cash flows.
2. Speculators
Speculators take educated gambles by buying or selling assets in hopes of short-term gains. Derivatives, especially options, are popular among speculators due to their low cost and high liquidity.
3. Arbitrageurs
Arbitrageurs exploit mispricings in assets to earn risk-free profits. They play a crucial role in keeping asset relationships in check, ensuring that prices remain fair and efficient.
4. Margin Traders
Margin traders use borrowed money to leverage their investments, amplifying potential gains but also increasing potential losses.
How are derivatives used by investors?
Derivatives primarily include financial instruments such as futures and forward contracts, swaps and options. The vast majority of non-professional traders and investors will probably only ever use futures and options, however.
Typically, investors use them to ‘hedge’ or protect against potential losses, to gain leverage by controlling a large position with a relatively small investment, or to exploit price differences in different markets. Let’s look at a typical use case for each type of derivative individually.
Futures and forward contracts
Futures and forward contracts are agreements to buy or sell an asset at a predetermined price on a specified date. Whereas futures are standardised contracts traded on exchanges (such as Nasdaq or the Deutsche Börse), forward contracts are customised agreements traded over the counter and settled at expiration.
A corn farmer, for example, might sell a futures contract to lock in the price of his corn before harvest, thereby safeguarding against a price drop. The farmer sells the futures at USD 5 per bushel on the exchange. If corn prices drop to USD 4.50 per bushel, the farmer would lose his money on the actual crop sale but gain in the futures market by buying back the contract at a lower price. If corn prices rise to USD 5 per bushel, the farmer earns more on the physical crop but loses on the futures trade. However, their price is locked in and the hedge protects against price declines while ensuring a predictable revenue stream.
Alternatively, if you trade in commodities, you might believe that the price of crude oil will increase in the next month. Let’s say, for example, that you expect the price to rise from USD 80 per barrel to USD 90 per barrel. If it rises to USD 90 per barrel, you can sell the futures contract and profit by USD 10 per barrel. If it falls to USD 70 per barrel, you lose USD 10 per barrel instead.
Swaps
Swaps are agreements to exchange cash flows based on different financial instruments or rates. It’s helpful to think of them as an agreement between two people to exchange something regularly, with one person getting a fixed payment and the other getting a variable payment. In fact, they don’t exchange any actual asset, but simply the cash flow based on its value. The most common types of swaps include interest rate swaps or currency swaps.
Take Sarah, a Swiss investor, who wants exposure to US equities but doesn’t want to deal with currency exchange risks. If she buys the US equities directly, she’s exposed to fluctuations in the USD/CHF exchange rate. However, if she enters a currency swap with a bank, she can borrow CHF and the bank borrows USD at an agreed-upon exchange rate. In other words, they swap principal amounts: Sarah receives USD, while the bank receives CHF.
Sarah invests the USD in US equities and earns interest in US dollars. Every quarter, she swaps interest payments with the bank, paying CHF interest to the bank, while the bank pays her the USD interest it earned from her equities. At the end of the swap period, they exchange back the original principal at the initial exchange rate. Sarah benefits from the US equity yield without currency risk. If the USD weakens, she still gets back the original amount in Swiss francs. Meanwhile, the bank profits by charging a small spread on the swap.
Options
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an asset at a fixed price before a certain date. Think of it like a reservation: you reserve a concert ticket for USD 50 in advance. If the ticket price goes up to USD 100, you benefit because you have already locked in the lower price. But if the price drops to USD 40, you can simply choose not to buy the ticket and let the reservation expire.
Let’s say Oliver owns 1,000 shares of the ABC Corporation, whose share price is currently USD 100. However, Oliver believes the share might decline in the short term due to upcoming earnings news, but he doesn’t want to sell his shares. To protect against potential losses, Oliver decides to buy put options, for a strike price of USD 95 and with an expiration date two months from today. The cost of buying these options, known as the premium, amounts to USD 3,000.
If the share price has dropped to USD 85 two months later, Oliver would exercise his put options, selling his shares at USD 95 instead of USD 85, thereby avoiding a USD 10,000 loss. His net loss would be USD 5,000, accounting for the USD 3,000 premium and the USD 2,000 loss from selling at USD 95 instead of USD 100. Alternatively, if the share price stays at USD 100 or increases, Oliver would let the put options expire and he would only lose the USD 3,000 premium. However, he would benefit from any increase in the share value.
In this example, the put options acted as a kind of insurance for Oliver, protecting him from a large downside. He has retained ownership of his shares while managing the risk, and his loss was limited to the cost of the options if the share price didn’t fall.
If you don’t understand the derivative, don’t buy it
Depending on the derivative, they are usually bought and sold either on a centralised exchange or through the over-the-counter market. Some derivatives are also traded on unregulated exchanges, making them challenging for the average investor to access, so seeking professional help might be useful.
Derivatives have sometimes had a bad reputation. Much quoted investor Warren Buffet called them “financial weapons of mass destruction” and they played a central role in the 2008 financial crisis. As with other financial instruments, however, it’s not the instrument itself that’s inherently dangerous but the misguided or overly risky use of it. Dabble in derivatives only when the main building blocks of your portfolio, such as your emergency funds, real estate holdings and retirement assets, are safely in place.
Used prudently, however, derivatives add an extra dimension to investing and can be adapted to your needs in terms of strategy, risk/return profile, maturity or the amount to be invested. As always in our popular ‘How to invest’ series: Building a balanced portfolio is key!