A guide to derivatives

Derivatives are financial contracts between two parties. The return depends on the performance of a specific underlying asset.

What are derivatives?

Derivatives are financial contracts between two parties. The return depends on the performance of a specific underlying asset.

There are two types of derivatives:

  1. Privately traded over-the-counter derivatives that do not go through an exchange or other intermediary. This is the type of derivative you can buy from financial service providers such as banks.
  2. Exchange traded derivatives bought and sold through specialised derivatives exchanges or other exchanges. These are standard contracts that you can buy and sell on an exchange without the need to interact with an intermediary like a bank.

The four most common types of derivatives are futures, forwards, options and swaps.

What are futures?

Futures are obligations to buy or sell an asset at an agreed price at a specified future date. Futures are standardised, which means they can be exchange traded. The value of the contract changes as the price of the underlying asset changes, and most contracts are settled in cash rather than in the physical exchange of goods.

What are forwards?

Forwards are like futures in that they are obligations to buy or sell an asset, often a foreign currency, at a specific price at a time in the future. Forwards differ from futures in that they are privately negotiated and customised. The contract size and the date can be tailored to the buyer’s specific needs.

What are options?

An option gives an opportunity, but not an obligation, to buy (call option) or sell (put option) a specific asset at a specific price. The buyer of an option will only exercise it if it is profitable to do so.

What are swaps?

A swap is a privately negotiated contract that allows two parties to trade different types of payments for a specified period of time. Payments can be based on a fixed interest rate, a floating interest rate or the performance of a currency, bond or stock index.

Why do businesses use derivatives?

Derivatives help companies manage risk and are increasingly used by firms seeking to protect themselves from the the volatility of financial markets.

The most common use for derivatives is to manage the risk of foreign currency fluctuations. For firms relying on imports, such as those that import raw materials, tools like futures and forwards allow them to lock in an agreed exchange rate in advance, which makes it easier to plan and manage cashflows. Similarly, exporters can use these tools to lock in an exchange rate at a future sale date, enabling them to better plan their cashflows.

Another common use of derivatives is to guard against changes in interest rates, or to take advantage of more favourable interest rates that a firm may not be able to access on their own. For instance, a firm that has a variable interest rate on a loan may enter into a swap which allows them to swap their variable interest payments for fixed interest rate repayments. Similarly, a company locked into a fixed interest rate may be able to save money by entering a swap which allows them to repay at a variable market rate.

The third most common use is using these tools to manage commodity-price fluctuations. For companies that rely on primary commodities such as coffee beans or grain, price fluctuations can be very problematic. Derivatives allow such companies to lock in a price for a future sale or purchase of goods.