ECONOMY

Financial Derivatives: Definition, Types, Risks

A derivative is an investment contract whose value derives from the underlying asset. The buyer agrees that he will purchase the asset at a certain price and date.

Derivatives can be used to trade commodities such as gold, oil, and gasoline. Currency, usually the U.S. Dollar, is another asset class. Derivatives are based on bonds or stocks. Other derivatives use interest rates such as the yield of the 10-year Treasury Note.

The seller of the contract does not have to be the owner of an asset. The seller can fulfill the contract if they give the buyer enough cash to purchase the asset at current market price. The seller can also offer the buyer a second derivative contract to offset the value of the original. Derivatives are much easier to deal with than assets themselves.

 

Derivatives Trading

In 2019, 32 billion derivatives contracts were traded. 1 The majority of the 500 largest companies in the world use derivatives to reduce risk. A futures contract, for example, promises raw materials will be delivered at a certain price. The company will be protected in the event of a price increase. Contracts are also used by companies to protect themselves against changes in interest rates and exchange rates.

Future cash flows are more predictable with derivatives. The companies can forecast their earnings with greater accuracy. This predictability increases stock prices and reduces the amount of cash businesses need to cover emergencies. This allows them to reinvest in their business.

Hedge funds and other investors are the main traders of derivatives to increase leverage. The “paying on Margin” is the only down payment required for derivatives.

Before the contract is completed, many derivatives are liquidated or offset by another derivative. They don’t care if they have enough money to pay the derivative off if the market turns against them. They cash out if they win.

Note:

Options that are traded over the counter between traders or companies that are familiar with each other are known as “over-thecounter” derivatives. These derivatives are traded via an intermediary, which is usually a large financial institution.

 

Exchanges

Only a small portion of derivatives traded in the world are traded at exchanges. The public exchanges standardize contract terms. These exchanges specify premiums and discounts on contract prices. Standardization increases the liquidity of derivatives. They become more or less interchangeable and thus more useful as a hedge.

Exchanges can act as clearinghouses, and be the buyer or seller for derivatives. This makes trading safer, as traders know that the contract will be met. The Dodd-Frank Wall Street Reform Act of 2010 was passed in response to financial crisis, and to reduce excessive risk-taking.

CME Group is the largest exchange. It is the result of the merger of Chicago Board of Trade with the Chicago Mercantile Exchange (also called CME or Merc). The exchange trades derivatives across all asset classes.

Stock options can be traded at the Chicago Board Options Exchange or NASDAQ. The Intercontinental Exchange (which acquired the New York Board of Trade) trades futures contracts. 3 This exchange focuses primarily on financial contracts and agricultural contracts.

These exchanges are regulated by the Securities and Exchange Commission or Commodity Futures Trading Commission. Trading Organizations and SEC Self-Regulating Organizations provide a list.

 

Types of financial derivatives

collateralized obligations are the most famous derivatives. CDOs are a major cause of the financial crisis of 2008. 4 They bundle debts such as credit card debts, auto loans or mortgages into a security valued on the promise of repayment.

Asset-backed commercial papers is based upon corporate and business debt. Mortgage-backed securities (MBS) are based on loans. The value of MBS and ABCP fell in 2006 when the housing market crashed. 5

Swaps are the most common derivative. A swap is an agreement that exchanges one asset or one debt for another similar asset. It is done to reduce risk for both parties. The majority of these are currency swaps and interest rate swaps.

A trader may, for example, sell stocks in the United States in order to hedge against currency risk. They are OTC and are not traded at an exchange. A company may swap the fixed-rate coupons of a bond with a variable rate payment stream from another company’s bonds.

Credit default swaps are the most notorious of all these swaps. The swaps also contributed to the 2008 financial crises. These were sold as insurance against defaults of corporate bonds, municipal bonds or mortgage backed securities.

There wasn’t sufficient capital when the MBS market crashed to pay CDS holders. The federal government was forced to nationalize American International Group. Dodd-Frank has allowed the CFTC to regulate swaps.

Another OTC derivative is forwards. These are contracts to buy or sale an asset for a price agreed upon at a future date. Both parties can customize the forward. Forwards can be used to hedge risks in commodities or interest rates.

Futures contracts are another important derivative. Commodities futures are the most common. The most important of these are oil futures, which set the price for oil and ultimately gasoline.

A derivative that gives the buyer the choice to buy or sell an asset at a specific price and date is another type.

Note:

Options are the most common. Call options are used to purchase a stock, while put options are used to sell it.

 

Four Risks in Derivatives

Derivatives pose four major risks. It’s nearly impossible to determine the real value of any derivative. This is by far the most dangerous. The value of the underlying asset is used to calculate its value. They are difficult to value because of their complexity.

Mortgage-backed securities are a major cause of economic decline. When housing prices fell, no one knew their value, not even computer programmers. The banks were unwilling to sell them as they could not value them.

leverage. Futures traders, for example, are only required by law to deposit 2% to 10% into a margin to maintain ownership. 6 In the event that the underlying asset’s value drops, the trader must increase the amount in the margin to maintain the percentage.

Covering the margin account could lead to huge losses if the commodity price continues to drop. The CFTC Education Center has a wealth of information on derivatives.

Their time limit is the third risk. Betting on the increase in gas prices is one thing. Predicting exactly when this will happen is another matter. Nobody who bought MBS expected housing prices to drop. Last time it happened was during The Great Depression. They also believed that CDS would protect them.

Due to the leverage, losses were multiplied throughout the economy. They were also unregulated and sold off exchanges. This is a unique risk for OTC derivatives. 7

The potential for scams is not the least. Bernie Madoff built his Ponzi scheme on derivatives. Fraud is prevalent in the derivatives markets. The CFTC’s advisory lists scams involving commodities futures.

 

FAQs (Frequently Asked Questions)

What are crypto derivatives?

Crypto derivatives are a great way to hedge your cryptocurrency exposure or speculate on it. Crypto derivatives are traded with equities, commodities and futures at the CME Group. An ETF that includes bitcoin futures is BITO. Traders can also trade options on BITO.

Crypto derivatives are also specialized futures traded on crypto exchanges such as BitMEX. These products are very similar to standard derivatives but are more leveraged and have different liquidation methods. 11

 

What types of derivatives are there?

Stock options — puts and calls — are perhaps the most well-known derivatives. But they’re not the only ones. Some stocks are issued with other derivatives like swaps or forwards. Although it’s not technically a stock derivative, traders can use futures such as NQ and ES as derivatives for the stock market.

the authorAaron Krause

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