What Are Derivatives?
Here we explain how derivatives work and discuss whether they should have a place in your investment portfolio.
Published on 22 January 2018
A derivative is a financial instrument that derives its value from an underlying asset. That asset could be a currency, a stock, a commodity, or a bond. In fact, there is a wide range of derivatives that you can trade in. There are even weather derivatives – the underlying “asset” in this type of derivative could be frost, rain, temperature, and wind.
The basic purpose of a derivative is to transfer risk from one party to another. Each derivative transaction has a long side and a short side. The long party can be compared to a buyer and the short party to the seller.
Remember that a derivative transaction does not involve a change in ownership of the underlying asset. But certain contracts do require a specific asset to be delivered at a future date.
You can enter into a derivative transaction on an exchange. For example, you may speculate on interest rates by trading in interest rate futures. A derivative can also be negotiated privately between two parties. As an exchange is not involved, this is referred to as an over-the-counter (OTC) derivative.
A futures contract, which is a derivative contract traded on an exchange, could be for a particular stock or an index. The contract would specify that the buyer is purchasing a specified quantity of the underlying asset at a specified price on a date in the future.
Futures contracts could be used by hedgers or by speculators. A hedger could be a company that wants to lock in the price of a certain commodity. So, an airline may want to enter into a futures contract for the aviation fuel that it requires. By doing this, it is attempting to control its level of risk for a major input cost.
Speculators have an entirely different motive. They predict the direction of the market with the intention of making a profit.
An option is another type of derivative contract. It gives you the right, but not the obligation, to buy or sell an underlying asset. The second leg of the transaction would take place on a certain date in the future and for a pre-specified quantity.
Do derivatives have a place in an investor’s portfolio? Or are they high-risk financial instruments that should be avoided? While derivatives do carry an element of risk, they can actually be used to protect your portfolio from market volatility.
Consider a situation where you think that the price of a stock that you own is going to fall. You could protect yourself by buying a put option for that stock – which would give you the right, but not the obligation, to sell a certain quantity of the underlying security, at a specified price within a specified time.
Now, if the price of the stock does fall, you will gain as you had purchased the put option. Of course, the shares that you own will also fall in value. However, if the stock’s price rises instead of falling, the money that you spent in buying the put option would have been a waste. But you would profit because of your original holding in the stock.
In this example, you have hedged your position (and protected yourself) by entering into a put option.
Legendary investor Warren Buffett has called derivatives a “weapon of mass destruction.” His statement seems prescient as it was made in 2002, six years before the global financial crisis. In 2008, Lehman Brothers – a financial services firm with assets of US$639 billion – collapsed because of the payouts that it had to make on its credit-default swaps (a type of derivative transaction).
Although the Lehman Brothers bankruptcy can be attributed to the collapse of the US housing market, the financial services firm’s indiscriminate exposure to derivatives also contributed to its early demise.
Another example that illustrates the damage that derivatives can do is provided by the loss that Société Générale, one of the biggest French banks, suffered some years ago. A rogue employee entered into a series of fraudulent derivative transactions on behalf of his employer. The loss? A massive €4.9 billion (US$5.9 billion).
Of course, this doesn’t mean that all derivative transactions carry a high level of risk and that you should avoid them altogether. But it is important to understand what you are getting into before you enter a trade.
Recently, bitcoin has gained a certain degree of legitimacy because Cboe Global Markets, an American company that owns the Chicago Board Options Exchange, has decided to allow futures trading of the cryptocurrency on its platform. Bitcoin is a high-risk investment, but trading in its futures could be even more dangerous.
The first day of trading in early December saw two occasions when transactions were temporarily suspended. A sharp increase in bitcoin futures prices triggered circuit breakers that had been put in place because of exchange rules.
Cryptocurrency brokers who operate on Cboe are playing it safe. They have insisted on high margins, which are as much as 44% of the trade value, and have also placed strict restrictions on the limits allocated to their customers.
A week after Cboe introduced bitcoin futures, rival CME Group, which owns and operates several derivative exchanges, launched its own bitcoin futures.
A basic tenet that you should follow is to invest only in those products that you understand. While certain derivative transactions can be quite straightforward, there are others that are more complicated. Entering into trades involving esoteric swaps and structured transactions that you don’t understand is highly inadvisable.
If your broker or financial advisor promotes a certain type of derivative that involves a great deal of complexity, it is a good idea to avoid buying that product. It is essential to understand which underlying asset the derivative is based on and the manner in which this affects the level of risk that you are taking.
Arthur Levitt, a former chairman of the Securities and Exchange Commission (SEC), the US federal agency tasked with monitoring the country’s financial markets, has accurately described derivatives as “… something like electricity; dangerous if mishandled, but bearing the potential to do good.”