Derivative Definition: Uses in Finance

What Is a Derivative?

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. 

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

An 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.

The risk-reward equation is often thought to be the basis for investment philosophy and derivatives can be used to either mitigate risk (hedging), or they can be used for speculation where the level of risk versus reward would be considered. For example, a trader may attempt to profit from an anticipated drop in an index’s price, such as the S&P 500, by selling (or going « short ») the related futures contract. Derivatives used as a hedge allow the risks associated with the underlying asset’s price to be transferred between the parties involved in the contract.

Derivative Exchanges and Regulations

Some derivatives are traded on national securities exchanges 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 Association (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.

OTC Transactions

It’s important to note that regulations can vary somewhat, depending on the product and its exchange. In the currency market, for example, the trades are done via over-the-counter (OTC), which is between brokers and banks versus a formal exchange. Two parties, such as a corporation and a bank, might agree to exchange a currency for another at a specific rate in the future. Banks and brokers are regulated by the SEC. However, investors need to be aware of the risks with OTC markets since the transactions do not have a central marketplace nor the same level of regulatory oversight as those transactions done via a national exchange.

Two-Party Derivatives

A commodity futures contract is a contract to buy or sell a predetermined amount of a commodity at a preset price on a date in the future. Commodity futures are often used to hedge or protect investors and businesses from adverse movements in the price of the commodity.

For example, commodity derivatives are used by farmers and millers to provide a degree of « insurance. » The farmer enters the contract to lock in an acceptable price for the commodity, and the miller enters the contract to lock in a guaranteed supply of the commodity. Although both the farmer and the miller have reduced risk by hedging, both remain exposed to the risks that prices will change.

Example of Commodity Derivative

For example, while the farmer is assured of a specified price for the commodity, prices could rise (due to, for instance, a shortage because of weather-related events) and the farmer will end up losing any additional income that could have been earned. Likewise, prices for the commodity could drop, and the miller will have to pay more for the commodity than he otherwise would have.

For example, let’s assume that in April 2020 the farmer enters a futures contract with a miller to sell 5,000 bushels of wheat at $4.404 per bushel in July. On the expiration date in July 2017, the market price of wheat falls to $4.350, but the miller has to buy at the contract price of $4.404, which is higher than the prevailing market price of $4.350. Instead of paying $21,750 (4.350 x 5,000), the miller will pay $22,020 (4.404 x 5,000), while the farmer recoups a higher-than-market price.

However, had the price risen to $5 per bushel, the miller’s hedge would’ve allowed the wheat to be purchased at a $4.404 contract price versus the $5 prevailing price at the July expiration date. The farmer, on the other hand, would’ve sold the wheat at a lower price than the $5 prevailing market price.

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.

Derivatives and Hedging

By entering into a futures contract, Gail is protected from price changes in the market, as she has locked in a price of $30 per bird. She may lose out if the price flies up to $50 per bird on a mad cow scare, but she will be protected if the price falls to $10 on news of a bird flu outbreak. By hedging with a futures contract, Gail is able to focus on her business and limit her worry about price fluctuations.

It’s important to remember that when companies hedge, they’re not speculating on the price of the commodity. Instead, the hedge is merely a way for each party to manage risk. Each party has their profit or margin built into their price, and the hedge helps to protect those profits from being eliminated by market moves in the price of the commodity. Whether the price of the commodity moves higher or lower than the futures contract price by expiry, both parties hedged their profits on the transaction by entering into the contract with each other.

Derivative Swap

Derivatives can also be used with interest-rate products. Interest rate derivatives are most often used to hedge against interest rate risk. Interest rate risk can occur when a change in interest rates causes the value of the underlying asset’s price to change.

Loans, for example, can be issued as fixed-rate loans, (same interest rate through the life of the loan), while others might be issued as variable-rate loans, meaning the rate fluctuates based on interest rates in the market. Some companies might want their loans switched from a variable rate to a fixed rate.

For example, if a company has a really low rate, they might want to lock it in to protect them in case rates rise in the future. Other companies might have debt with a high fixed-rate versus the current market and want to switch or swap that fixed-rate for the current, lower variable rate in the market. The exchange can be done via an interest-rate swap in which the two parties exchange their payments so that one party receives the floating rate and the other party the fixed rate.

Example of Interest Rate Swap

Continuing our example of Healthy Hen Farms, let’s say that Gail has decided that it’s time to take Healthy Hen Farms to the next level. She has already acquired all the smaller farms near her and wants to open her own processing plant. She tries to get more financing, but the lender, Lenny, rejects her.

Lenny’s reason for denying financing is that Gail financed her takeovers of the other farms through a massive variable-rate loan, and Lenny is worried that if interest rates rise, she won’t be able to pay her debts. He tells Gail that he will only lend to her if she can convert the loan to a fixed-rate loan. Unfortunately, her other lenders refuse to change her current loan terms because they are hoping interest rates will increase, too.

Gail gets a lucky break when she meets Sam, the owner of a chain of restaurants. Sam has a fixed-rate loan about the same size as Gail’s, and he wants to convert it to a variable-rate loan because he hopes interest rates will decline in the future.

For similar reasons, Sam’s lenders won’t change the terms of the loan. Gail and Sam decide to swap loans. They work out a deal in which Gail’s payments go toward Sam’s loan, and his payments go toward Gail’s loan. Although the names on the loans haven’t changed, their contract allows them both to get the type of loan they want.

The transaction is a bit risky for both of them because if one of them defaults or goes bankrupt, the other will be snapped back into their old loan, which may require payment for which either Gail or Sam may be unprepared. However, it allows them to modify their loans to meet their individual needs.

Credit Derivative

A credit derivative is a contract between two parties and allows a creditor or lender to transfer the risk of default to a third party. The contract transfers the credit risk that the borrower might not pay back the loan. However, the loan remains on the lender’s books, but the risk is transferred to another party. Lenders, such as banks, use credit derivatives to remove or reduce the risk of loan defaults from their overall loan portfolio and in exchange, pay an upfront fee, called a premium.

Example of Credit Derivative

Lenny, Gail’s banker, ponies up the additional capital at a favorable interest rate and Gail goes away happy. Lenny is pleased as well because his money is out there getting a return, but he is also a little worried that Sam or Gail may fail in their businesses.

To make matters worse, Lenny’s friend Dale comes to him asking for money to start his own film company. Lenny knows Dale has a lot of collateral and that the loan would be at a higher interest rate because of the more volatile nature of the movie industry, so he’s kicking himself for loaning all of his capital to Gail.

Fortunately for Lenny, derivatives offer another solution. Lenny spins Gail’s loan into a credit derivative and sells it to a speculator at a discount to the true value. Although Lenny doesn’t see the full return on the loan, he gets his capital back and can issue it out again to his friend Dale. Lenny likes this system so much that he continues to spin out his loans as credit derivatives, taking modest returns in exchange for less risk of default and more liquidity.

Options Contracts

Years later, Healthy Hen Farms is a publicly-traded corporation (HEN) and is America’s largest poultry producer. Gail and Sam are both looking forward to retirement.

Over the years, Sam bought quite a few shares of HEN. In fact, he has more than $100,000 invested in the company. Sam is getting nervous because he is worried that another shock, perhaps another outbreak of bird flu, might wipe out a huge chunk of his retirement money. Sam starts looking for someone to take the risk off his shoulders. Lenny is now a financier extraordinaire and active writer or seller of options, agrees to give him a hand.

Lenny outlines a deal–called a put option–in which Sam pays Lenny a fee–or premium–for the right (but not the obligation) to sell Lenny the HEN shares in a year’s time at their current price of $25 per share. If the share prices plummet, Lenny protects Sam from the loss of his retirement savings.

Healthy Hen Farms remains stable until Sam and Gail have both pulled their money out for retirement. Lenny profits from the fees and his booming trade as a financier. Lenny is OK because he has been collecting the fees and can handle the risk.

The Bottom Line

This tale illustrates how derivatives can move risk (and the accompanying rewards) from the risk-averse to the risk seekers. Although Warren Buffett once called derivatives « financial weapons of mass destruction, » derivatives can be very useful tools, provided they are used properly. Like all other financial instruments, derivatives have their own set of pros and cons, but they also hold unique potential to enhance the functionality of the overall financial system.