Derivatives are contracts used in finance that derive their own value from the value of an underlying entity. That entity can be either an asset, index, or interest rate, but is normally an asset. It is the contractual agreement itself that is the derivative and not the underlying entity. As the performance of the underlying entity changes (as it changes in value), so does the value of the contractual agreement for each party that is involved.
Derivatives are one of the three main financial instruments. The others are equity and debt.
The most basic example of a derivative is a forward contract for a commodity, like grain.
In a forward contract of this kind, one party will usually agree to buy a fixed amount of grain at a fixed price on a future date. This specific agreement (which is set out in a contract) is the derivative itself.
When the date comes at which the agreement must be completed, both parties will have to complete the sale of grain at the price set in the forward contract. This is regardless of whether the current market rate for grain at that time is different. The difference in price for grain between the rate set in the forward contract and the current market rate determines the value of the forward contract.
If the current value of grain at that time is indeed different from the rate set in the forward contract, then one party will incur a cost as a result of the forward contract and one party will generate a profit.
While this gives a basic example of how a derivative works, they can be adapted in a variety of ways. Any agreement made in a derivative will set out the conditions under which payments are to be made between the parties involved at a future date. These conditions will normally be the dates on which payments are made, the value of the underlying entity, the amount of that entity, the definitions of the underlying variables, and the parties’ specific contractual obligations.
The basic idea behind derivatives (to buy and sell something at a certain price in the future) is so fundamental to trade that it is impossible to say where derivatives come from. While their use is more formalised nowadays and takes up a larger share of total financial transactions, they have been in use for a long time.
The Greek philosopher Thales of Miletus created a well-known early form of the derivative when he negotiated the rental price of olive oil presses ahead of time after he predicted a good year for olive oil production. His prediction was correct and the agreement he had secured earned him a profit.
What Thales did specifically predicted a good year for olive oil ahead of time using his knowledge of astronomy. He then, in advance, agreed to rent olive oil presses from the press owners at the time in the future when those presses would be in increased demand. This agreement is the same as a forward contract. Thales’ prediction that there would be a good harvest was correct and he was able to have a monopoly over olive oil press sub-lease prices when demand was high.
The obvious use of derivatives is in speculation for profit, as in the example of Thales (remembering that he could have made a loss if olive oil harvests turned out to be poor enough). However, ironically, they can also be used to hedge against financial risk.
The issue of hedging against financial risk is a specialism of Bound’s (the writers of this article). We specialise in providing derivatives through which companies that trade in foreign currencies can protect themselves from the risk of being negatively affected by changes to the exchange rate.
Speculators can use derivatives to attempt to either buy an asset in the future at a low price when the market price will be high or to sell an asset in the future at a high price when the market price will be low. Obviously, the difference between the market price and the price they either buy or sell at with the derivative will determine whether they make a profit or a loss. The speculation comes with risk and can lead to loss as well as profit.
Arbitrage is the practice of taking advantage of a difference in price between different markets. With derivatives, where the same or similar derivatives are available for different prices in different markets, an opportunity for arbitrage exists.
There are various ways that derivatives can be used to hedge against financial risk.
As a simple example, a party that has an asset that it will sell at a future date can use a derivative to protect themselves from the risk that the value of that asset will fall before it is time to sell it. What this party can do is find a counterparty with which to agree on a forward trade with a forward contract. The counterparty will agree to buy the total quantity of the asset that they would like to sell at a certain price on or before a certain date.
The party holding the asset are then protected from any fall in the price of the asset itself. While this is the case, strictly speaking, what happens is that both parties remove one risk, while opening themselves up to another.
For the party which will sell the asset, the risk of them having to sell their asset below a certain price is removed. However, they are exposed to the risk that the asset will actually be worth more when the contract is completed. In this case, they will lose the ability to benefit from this change in value. The other party in a forward contract takes the opposite position with respect to risk. They are insured against the risk that the price of the asset will go beyond a certain point but are exposed to the risk that they will pay over the market value for it when the contract is completed.
Given that there seems to be an equal general level of risk associated with buying and selling assets, it may seem that there is no obvious reason to hedge against risk. A business that owns an asset, while it may lose out at certain times, might be equally likely to benefit at other times. If this is the case, then why hedge against risk?
The reason that hedging is carried out is that many businesses or individuals, particularly businesses, rely on having certainty. While the net difference may be equal if hedging is not carried out, the timing of having shortfalls and excesses of funds may not coincide with the requirement for funds. Particularly in business, having certainty about cash flows allows future business operations to be planned successfully. This in turn allows a business to actually operate successfully.
Derivatives are often used by businesses that are looking to hedge against risk associated with changes to exchange rates. This type of risk is common for businesses that trade internationally or have overseas assets and is known as currency risk.
There are a number of ways that currency risk can affect different businesses and a number of ways that it can be tackled with derivatives. Some methods are simple and some are more complicated. However, we can use forward trades again to give a simple example.
In this case, a business could agree to sell a fixed amount of its domestic currency (this amount of currency is an asset) in return for a fixed amount of foreign currency on or before a certain date in the future. By doing so, they will have fixed the exchange rate for that future date. In this case, they will be able to plan to exchange an amount of their domestic currency at a certain rate for a future date to complete a specific transaction that is planned in the foreign currency in question.
In a similar respect, a company that is planning to convert foreign currency into its domestic currency could take the opposite position (buy the domestic currency and sell the foreign currency) in a similar derivative contract.
There are two fundamental types of derivative contracts, which are lock or option types.
With lock derivatives, there is an obligation to complete the exchange that is agreed to in the contract. If, for example, you agree to sell grain to a buyer at a certain price in the future through a forward contract, you are contractually obliged to actually sell that grain.
Option contracts, on the other hand, give one party the right but not the obligation to buy or sell something under the conditions agreed to in the contract. This means that when the time comes to complete the deal agreed in the option trade (before the expiry date), that party can decide whether they want to or not. Someone selling grain, for example, when the contract expires may see that the market price for grain is actually higher than the price set in the option trade. They can then choose not to use the option trade.
While option trades give flexibility, there is an upfront cost, known as a premium, associated with taking one out.
The risks that are in place during the lifetime of a derivative contract are fundamental to how they work. Any party involved in a derivative contract is looking to position themselves in a certain way with respect to risk.
The ultimate difference between the price set in the derivative and the market price when the contract is completed determines what the derivative turns out to be worth.