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Jan 27, 2025

Basics

Derivatives in Finance: Learn Their Definitions, Functions, and Risks

Introduction

Derivatives in the world of investments are financial contracts whose value is intrinsically linked to an underlying asset, like bonds, interest rates, commodities, and even currencies.

They are complex financial instruments with multiple applications, from risk management to speculation. Together with equity and debt, derivatives form a third important category of financial tools that can be used by experienced investors to handle their portfolios.

With a considerable market size and considerable strategic importance, derivatives and their characteristics are essential for investors of all kinds to form a better comprehension.

If you want to learn more, keep reading to familiarize yourself with common types of derivatives, and to decide if they could be useful for your financial goals.

Definition of derivatives in the financial world

At their core, derivatives are financial contracts between two parties that agree to exchange an asset if some predetermined conditions are met.

What those conditions are can vary, but the most important ones are usually price variation, quantities of the asset in question, and expiration dates.

As the word suggests, some derivatives derive their value from an underlying asset. They are an important tool for getting more exposure to notoriously difficult assets to access, like more expensive or complex ones.

Derivatives can be used to access a super expensive asset like bitcoins. With them, you don’t need the funds to actually own lots of bitcoins to leverage your gains. If the price goes up, you can benefit from that with a significantly small margin. If the price goes down, however, you can also suffer bigger losses.

The underlying assets of derivatives can be pretty much anything, ranging from tangible goods like commodities and real estate, to intangible financial assets like stocks, indexes, interest rates, and even cryptocurrencies.

That’s one of the reasons they are so important for the market. But, with such great versatility also come more complex situations and types of contracts.

Features and usage of derivatives

Derivatives are very detailed and are created based on many different characteristics and aspects.

The main ones are expiration dates, strike prices, and quantities of the asset in question, but there are also more specific ones like settlement method (cash or physical), margin requirements, pricing models, and so on.

Another way to look at derivatives is by dividing them into “lock” and “option” ones. In the former, you are obliged to fulfill the contract. In the latter, it’s optional.

The absence of ownership is an additional important feature of derivatives. Investors can expand their exposure to assets they find interesting without the need to own any of them.

Because of the diversified nature of these contracts, they can serve many purposes, such as securing a desired price in the future, maximizing gains through leverage and speculation, diversifying a portfolio by accessing different types of assets, and many more.

Additionally, since derivatives are multifaceted and have their own risks, regulation plays a big part in their market. This is most obvious when it comes to exchange-traded derivatives that are heavily regulated and can only be traded with the help of an intermediary party.

There are over-the-counter (OTC) derivatives and they are still the major part of the market, but, due to emerging regulations, more and more OTC derivatives can become exchange-traded ones.

Main categories of derivatives

The two main categories of derivatives are over-the-counter (OTC) and exchange-traded. An extra classification is vanilla versus exotic. Below is a concise explanation for each:

Over-the-counter (OTC) derivatives

OTC derivatives are contracts negotiated between two private parties without an intermediary. The parties are free to decide their own terms, and the deals feature additional privacy.

Because there are no regulating parties in the middle, these contracts are riskier since, like any regular contract, they are entirely dependent on the other party to fulfill their part of the deal.

But despite that, they have the advantage of giving more flexibility and adaptive powers to both parties, leaving them free to decide what’s more important to each of them in the contract clauses.

Since OTC derivatives are privately negotiated, it’s harder to get information on them and have accurate numbers of their market.

Exchange-traded derivatives

ETD derivatives are standardized contracts that follow a set of rules predetermined by regulated exchanges.

These official exchanges work as an intermediary third party, mediating the fulfillment of contracts according to their specific rules and expectations.

Because this intermediary exists, these kinds of derivatives offer much lower risk compared to their OTC counterparts. Also, the exchanges usually require an initial margin from both parts of the deal, actively working as a guarantee for both of them.

Considering those mentioned factors, exchange-traded derivatives are more transparent and safe, but they also suffer from less flexibility.

According to Statista, as of 2023 the National Stock Exchange of India was the largest derivatives exchange in the world with 85 billion derivatives contracts. The second was B3, the Brazilian exchange, with 8.3 billion contracts.

Vanilla and exotic derivatives

Another famous classification of derivatives are vanilla (or plain vanilla) and exotic. These are hard-to-define terms as they are usually used in an informal way, but their gist is that vanilla refers to more commonly traded derivatives, while exotic refers to precisely the opposite: more rare and more complex ones.

The exotic part of these contracts can refer to their high volatility, the fact that they have multiple underlying assets, or even their barrier of entry.

Because of that higher complexity, they are usually traded by experienced investors in the over-the-counter market.

Main types of derivatives instruments with examples

Futures contracts

Futures contracts are standardized contracts that legally bind the holder to the obligation to sell or buy a specific amount of an asset for a predetermined price at a specific date in the future. They are a famous type of exchange-traded derivative and therefore have less risk.

The usual goal of a futures contract is to protect oneself from undesired price fluctuations, so they are a hedging tool that can help mitigate risk and increase control of the asset’s value.

Example: A classic example of a futures contract is when a farmer wishes to safeguard their livelihood from sudden variations in the price of the commodity they grow and harvest. They can then set a contract stating that they will sell in the future for a predetermined price, protecting themselves from volatility.

Note: this works in both directions, because if the price actually grows higher than the predetermined one, the farmer will have limited his earnings.

Forward contracts

Forward contracts are the same as futures contracts. The only difference is that they are traded over-the-counter and therefore have more risk.

Since there is no clearing house to act as an intermediary, the parties can adjust the contract to fit their needs. However, the counterparty risk is higher because each party has to trust that the other will act accordingly, especially in the event of significant losses for one of them.

Options

Options are derivatives contracts where the holder has the right but not the obligation to sell or buy an asset for a predetermined price on or before a specific date.

Since they are optional contracts, as their name suggests, the holder can exercise this right or not, depending on what’s more beneficial to them. When an option refers to the right to buy, it’s called a call option. Inversely, when it refers to the right to sell, it’s called a put option.

To buy this right, the holder has to pay a price, commonly known as the premium payment. Many options are exchange-traded derivatives, but there are over-the-counter ones as well. These kinds of derivatives are well regarded by investors since they are not that complicated to manage and can be used to hedge against increased risk.

Example: A trader can buy a put option to have the right to sell a specific currency pair at a predetermined desired exchange rate. So if the official exchange rate goes down, the trader will be protected.

Swaps

Swaps are derivatives where the two parties agree to exchange cash flows or liabilities at some point in the future from both of their financial instruments. They are usually traded over-the-counter and can be useful for hedging against various risks, most commonly ones related to interest rates or credit.

Example: Two parties can exchange bonds that have different interest rates. One could have a fixed rate and the other a fluctuating one. Depending on the market scenario, both parties could benefit from the swap.

Most common applications of derivatives

Derivatives can be used for many different purposes, but the main ones are listed below.

Hedging

Hedging is an incredible strategy to mitigate risk and offset or reduce your losses if something undesirable happens. With derivatives, especially instruments like futures contracts and options, you can hedge your investments against many types of risks, including price fluctuations, exchange rate volatility, and more.

Speculation

Speculators can take advantage of derivatives liquidity and small costs to benefit from favorable changes in the market without the need to own the assets or invest large amounts of money. This increases their leverage power but it’s also a double-edged sword since speculators can be on the wrong side of the market and face bigger losses.

Diversification

Derivatives can be useful instruments to enlarge your exposure to many different assets, especially more complex or expensive ones. It’s an important tool to diversify your portfolio and make sure you are not making the mistake of putting all of your eggs in an uncertain and unfavorable basket.

Arbitrage

Derivatives can help arbitrageurs take advantage of the price difference for the same asset between different markets with more flexibility and efficiency. Factors like small margins and costs can help them profit more and act more quickly when an arbitrage opportunity appears.

The size of the derivatives market

When talking about notional values, the derivatives market appears to have a gigantic value estimated at $729.8 trillion as of mid-2024 for over-the-counter derivatives, according to ISDA.

However, some specialists argue that these numbers are largely overestimated, considering that notional values consider the value of the underlying assets as a whole and not only the value of the derivatives contracts themselves.

In any case, the significance of the derivatives market is undeniable – not only because of its size but also, perhaps most importantly, because of its importance to the financial system altogether.

Important risks to consider

The complex and detailed nature of derivatives means they present various types of risks, each one with specific details and management methods.

The first one is the relation to the underlying asset itself. Derivatives will always be linked to variations in the asset value and if those changes are very sudden or surprising, the losses can be amplified.

The same goes for leverage risks. Leverage with derivatives can be a powerful way to maximize gains with minimal investments, but it also means the losses will be maximized as well, sometimes in unexpected ways.

Another important risk is the inherent chance that the other party of a contract will fail to fulfill their part of the deal, especially with over-the-counter derivatives that don’t have the protection of an intermediary.

Lastly, lack of judgment, pricing mistakes, and difficulty in complying with regulations can become more detrimental when it comes to derivatives.

In summary, derivatives can be great tools in a portfolio, however, they require extra attention and a good understanding of risk management.

Increasing regulation

The same characteristics that make derivatives powerful also mean they can offer greater risks to the stability of the market as a whole.

Derivatives like credit default swaps and collateralized debt obligations were linked to the 2007-2008 housing market crisis in the United States. While they weren’t a direct cause, many agree they made things worse and more complicated during that period.

That’s one of the reasons regulations for the derivatives market have been increasing for a long time, focusing on increasing transparency and decreasing the chance of systemic risks.

Two of the main regulatory frameworks today are the Dodd-Frank Act in the United States and EMIR (European Market Infrastructure Regulation) in Europe. They focus on reporting rules and clearing obligations, aiming to enhance the protection of market stability.

Summary

Derivatives are essential instruments for experienced investors to diversify their portfolios, hedge their risks, and amplify their potential gains.

While they are complex tools that require more market expertise and research, they can make significant differences in many investment strategies. Even if you don’t think they are a good fit for you, knowing the basics about them will definitely help you navigate the financial world with more ease and confidence.

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