What Are Derivatives?

Derivatives are financial instruments used by experienced investors, consisting of contracts whose value depends on an underlying asset. Common types include options, futures, forward contracts, and warrants. Although the basic concept is straightforward, derivatives can become complex in practice. If you’re interested in exploring derivative investing but don’t want to lose your way, consider seeking the help of a financial advisor.

What Are Derivatives?

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. However, 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.”

Types of Derivatives

While derivatives can be complex, understanding their types and applications can help you navigate the financial markets more effectively. Below we will explore the primary types of derivatives, their characteristics and their uses.

1. Credit Derivatives

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.

2. Call Options

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 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 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.

3. Forward Contracts

Forward contracts are agreements between two parties to buy or sell an asset at a specified price on a future date. These contracts are not standardized and are typically traded over the counter (OTC), meaning they are privately negotiated. Because of their customization, forward contracts can be tailored to meet specific needs but carry a higher counterparty risk since they lack the backing of an exchange. Businesses often use forwards to hedge against price fluctuations in commodities or currencies.

4. Futures Contracts

Similar to forwards, futures contracts involve an agreement to buy or sell an asset at a predetermined price on a specific date. However, unlike forwards, futures are standardized and traded on regulated exchanges. This standardization ensures transparency and reduces counterparty risk, as clearinghouses guarantee the performance of the contracts. Futures are commonly used for commodities like oil and gold, as well as financial instruments such as indices and interest rates.

5. Call Swaps

Swaps are agreements between two parties to exchange financial cash flows or instruments. The most common types are interest rate swaps, where fixed-rate payments are exchanged for floating-rate payments, and currency swaps, which involve exchanging principal and interest payments in different currencies. Commodity swaps, another variation, allow parties to exchange fixed payments for floating commodity prices.

Derivatives play a critical role in the financial ecosystem, offering tools for risk management, speculation, and arbitrage. Each type of derivative serves specific purposes and caters to different market participants.

Derivative Trading

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.

Bottom Line

To be 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 a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can 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.