Derivatives

A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset (like a security) or set of assets (like an index). Common underlying instruments include bonds, commodities, currencies, interest rates, market indexes, and stocks. 

  • A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, index, or security.
  • Futures contracts, forward contracts, options, swaps, and warrants are commonly used derivatives.
  • Derivatives can be used to either mitigate risk (hedging) or assume risk with the expectation of commensurate reward (speculation).

Understanding Derivatives

Derivatives are secondary securities whose value is solely based (derived) on the value of the primary security that they are linked to–called the underlying. Typically, derivatives are considered advanced investing.

There are two classes of derivative products: “lock” and “option” Lock products (e.g. swaps, futures, or forwards) bind the respective parties from the outset to the agreed-upon terms over the life of the contract. Option products (e.g. stock options), on the other hand, offer the holder the right, but not the obligation, to buy or sell the underlying asset or security at a specific price on or before the option’s expiration date. While a derivative’s value is based on an asset, ownership of a derivative doesn’t mean ownership of the asset. Futures contracts, forward contracts, options, swaps, and warrants are commonly used derivatives.

Futures Contracts

A futures contract, for example, is a derivative because its value is affected by the performance of the underlying asset. A futures contract is a contract to buy or sell a commodity or security at a predetermined price and at a preset date in the future. Futures contracts are standardized by specific quantity sizes and expiration dates. Futures contracts can be used with commodities, such as oil and wheat, and precious metals such as gold and silver.

Equity Options

Equity or stock option is a type of derivative because its value is “derived” from that of the underlying stock. Options come in forms: calls and puts. A call option gives the holder the right to buy the underlying stock at a preset price (called the strike price) and by a predetermined date outlined in the contract (called the expiration date). A put option gives the holder the right to sell the stock at the preset price and date outlined in the contract. There’s an upfront cost to an option called the option premium.

Derivative Exchanges and Regulations

Some derivatives are traded on a national securities exchange and are regulated by the U.S. Securities and Exchange Commission (SEC). Other derivatives are traded over-the-counter (OTC), which involve individually negotiated agreements between parties.

Futures

Most derivatives are traded on exchanges. Commodity futures, for example, trade on a futures exchange, which is a marketplace in which various commodities are bought and sold. Brokers and commercial traders are members of the exchange and need to be registered with the National Futures Exchange  (NFA) and the Commodity Futures Trading Commission (CFTC).

The CFTC regulates the futures markets and is a federal agency that is charged with regulating the markets so that the markets function in a fair manner. The oversight can include preventing fraud, abusive trading practices, and regulating brokerage firms.

Options

Options contracts are traded on the Chicago Board Options Exchange (CBOE), which is the world’s largest options market. The members of these exchanges are regulated by the SEC, which monitors the markets to ensure they are functioning properly and fairly.

Benefits of Derivatives

Let’s use the story of a fictional farm to explore the mechanics of several varieties of derivatives. Gail, the owner of Healthy Hen Farms, is worried about the recent fluctuations in chicken prices or volatility within the chicken market due to reports of bird flu. Gail wants to protect her business against another spell of bad news. So she meets with an investor who enters into a futures contract with her.

The investor agrees to pay $30 per bird when the birds are ready for slaughter in six months’ time, regardless of the market price. If at that time, the price is above $30, the investor will get the benefit as they will be able to buy the birds for less than the market cost and sell them on the market at a higher price for a profit. If the price falls below $30, Gail will get the benefit because she will be able to sell her birds for more than the current market price, or more than what she would get for the birds in the open market.

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