Derivatives are a type of financial instrument traded by more advanced investors. A derivative is a contract between two parties that depends on an underlying asset of some kind to determine its value. Options, futures, forward contracts and warrants are all forms of derivatives.
While the concept of a derivative is simple enough, things can quickly become complex. If you’re interested in exploring derivative investing but you don’t want to lose your way, consider seeking the help of a financial advisor.
Derivatives: A Definition
A derivative is a financial instrument that is “derived” from an underlying asset or transaction. Futures, for example, are a basic form of derivative. In a typical futures contract, a corn producer might agree to sell her corn at a certain price in the future. The other party to the futures contract agrees to buy at that price at the established date.
The risk in the futures contract stems from the fact that one party will lose out, either from agreeing to buy at too high a price or agreeing to sell at too low a price. That original contract can then be sold on to others, transferring the risk.
These days, the derivatives market has expanded and become more sophisticated. It’s a way to make money off of risk without actually purchasing an underlying asset like a commodity, loan, stock, foreign exchange or government bond. Because they’re higher-risk financial instruments, derivatives are generally traded by institutional investors, not retail investors.
Some individual day traders do trade derivatives. But your typical individual investor with a 401(k) and some savings in the bank probably doesn’t need to dabble in derivatives trading. To give you an idea of the risks involved, Warren Buffett once described derivatives as “weapons of mass destruction.”
A credit derivative is a way to transfer credit risk. Remember the Credit Default Swaps (CDSs) that became famous during the 2008 financial crisis? Those are a type of credit derivative. A CDS is a derivative of a loan (or several loans) between a lender and a borrower. That loan is known as the reference obligation.
The buyer of a CDS (also known as the Protection Buyer) makes regular periodic payments to the seller (also known as the Protection Seller). If the original borrower defaults, the seller of the CDS pays the buyer what is known as a contingency or conditional payment. In a sense, the buyer of a CDS is “shorting” the original loan – betting that the borrower will default. The value of the conditional payment can be a pre-determined amount, or it can equal the difference between the face value of the loan and the amount recovered by the reference entity.
Credit derivatives can be risky business because the buyers of Credit Default Swaps are vulnerable to what’s called counterparty risk. There are two counterparties in a derivatives deal. One counterparty is the entity that is selling (also known as writing) the CDS. They’re the ones who promise to pay the buyer in the event of a default on the reference obligation. But what happens if the counterparty itself defaults? If that happens, the buyer is out of luck. And if that happens on a large scale, the effects ripple throughout the financial system, as they did in 2008.
Another common form of derivative is a call option. The buyer of a call option is buying the right to buy stock at a certain price (the “strike price”) and at a certain date (the “expiration date”). It’s an “option” because the buyer isn’t obligated to the buy stock when the date rolls around.
The buyer of the call option is hoping that the stock price will rise beyond the strike price. That way, he or she can buy shares for the agreed-upon price of, say, $100 when the stock is actually worth $120. That’s a win. If the share prices don’t rise enough to make it worthwhile for the investor to exercise his options, he’s lost the money he spent buying the call options.
The world of derivatives trading exists on a separate plane from the reference obligations that underlie the derivatives. The reference entity (the company, government or other institution that issues a loan) doesn’t necessarily know about the goings-on in the derivative of that loan.
The reference entity’s credit risk on the loan transfers to the derivatives market, where it can trade freely. The seller of the derivative is selling the risk on the reference obligation. The seller and the buyer have a whole new contract. In the event of a default or other credit event, if the reference entity can’t pay up, the seller of the derivative pays the buyer.
For the purpose of being a well-informed citizen, it’s important to know what derivatives are and how they work. But that doesn’t necessarily mean you should rush off and invest in derivatives yourself. As an individual investor without a high level of expertise and cash, you might find you are better off leaving the derivatives markets to the professionals.
Tips for Investing Responsibly
- If you think that derivatives have a role to play in your portfolio, you should strongly consider consulting with a financial advisor to help you navigate these complicated instruments. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- Asset allocation is a key element for investors when it comes to balancing the risk of their portfolios. Investors with ample disposable income might choose a riskier asset allocation. Someone nearing retirement age, however, may want to be more conservative. SmartAsset’s asset allocation calculator can help you figure out the allocation that makes the most sense for you.
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