What are Derivatives in Finance?
In finance, the term “derivative” refers to the financial instrument whose value is derived on the basis of the underlying asset. A derivative represents a financial contract between two or more parties and its price is decided based on the fluctuations in the price of the underlying asset. Some of the most common examples of underlying assets are commodities, bonds, stocks, currencies, etc. Derivative instruments are purchased through exchanges or over-the-counter.
Typically, derivatives are either used as a hedging instrument or speculating directional movement of the underlying asset. As such, derivatives derive their value from the fluctuations in the value of the underlying asset.
The need for derivatives came from the international traders who wanted to safeguard themselves against the fluctuations in exchange rates. Hence, derivatives were initially introduced to hedge the movement in exchange rates for internationally traded goods. However, derivatives have gained a wide range of utilities over period of time. In fact, today there are derivatives for managing risks associated with unexpected weather changes.
Examples of Derivatives in Finance
Following are the examples are given below:
Let us take the example of the WTI oil price future contract to illustrate the concept of derivatives. Let us assume that in April 2020 ABC Inc., when WTI oil was trading at $19.10 per barrel, purchased10 futures contracts for WTI oil at a price of $30.00 per barrel that expires on 31st August 2020. Each future contract represents 1,000 barrels of oil. Basically, the company anticipated a steep increase in oil prices in the near term, and in this way, the company restricted its risk as the seller of the derivative will now be obligated to deliver oil to the company for $30.00 per barrel at the time of the contract expiry.
Now, during August 2020, the WTI oil prices went upto $42.61 per barrel, which means per barrel the company made a profit of $12.61 (= $42.61 – $30.00). So, at the expiry of the contract ABC Inc. made total profit of $126,100 (= $12.61 * 1,000 barrels * 10 future contracts). This is how future contract works.
Let us now take the example of a swap option. Let us assume that ABC Inc. has raised $1 million of fund in the form of debt and pays a variable rate of interest, currently 5%. On the other hand, XYZ Inc. has also borrowed $1 million in debt, but it pays a fixed rate if the interest of 6%. Now, ABC Inc. is apprehensive that the interest rates may rise in the near term, while XYZ Inc. intends to take advantage of the current lower floating rate. As such, both the companies enter into a swap contract under which ABC Inc. will be paying the fixed interest rate (6%) and XYZ Inc. will be paying the variable interest rate (5%).
At the start of the swap, ABC Inc. will have to pay 1% (= 6% – 5%) of the debt to XYZ Inc. as the difference between the two interest rates. However, if the interest rates fall such that the variable rate becomes 4%, then ABC Inc. will have to pay XYZ Inc. 2% (= 6% – 4%) as the difference between the two interest rates. On the other hand, if the interest rates rise to 7%, then XYZ Inc. will have to pay ABC Inc. 1% (= 7% – 6%) as the difference between the two interest rates. This is how a swap option works.
Types of Derivatives in Finance
There are three broad categories of derivatives in finance. They are – Forward contracts, Future contracts and Options.
- Forward Contracts: In this type of hedging instrument, two or more parties are involved. The agreement is done at a specified price decided by the participating parties (buyers and sellers) irrespective of the current market price of the underlying asset, and after that the seller will be obligated to deliver the asset happens on a specified future date at the said price. In this way, the buyer of the instrument can hedge the risk to a certain level.
- Future Contracts: A future contract is also more or less similar to forward contract. The only difference between a future contract and a forward contract is that the former can be transferred, which makes it more liquid in nature compared to a forward contract. Basically, the buyer has the flexibility to enter into a new contract and shift the previous obligation to buy to someone else.
- Options: In this type of contract,there is no liability and the return primarily depends on the occurrence of certain market events. Basically, the holder of an option has the choice to exercise the right to buy or sell an asset, but no obligation. The call option gives the right to buy an asset and the put option gives the right to sell an asset at a pre-determined price known as the strike price of the option.
Risk of Derivatives in Finance
The major risks associated with derivative instruments are:
- Inability to properly value a derivative instrument due to its complicated nature exposes the involved parties to the risk of huge losses.
- Given that derivatives are also used for speculation purposes, unpredictable behavior of the underlying asset may lead to huge losses.
- Some of the contracts that are traded over-the-counter are vulnerable to the risk of counter-party default as theylack proper due diligence.
Why to Use Derivatives in Finance?
Derivative instruments are used for the following purposes:
- To hedge risk associated with the value of the underlying asset.
- To speculate and book profit in case of favorable movement in the underlying asset.
- To gain exposure to certain exotic underlying assets, which is not possible otherwise (e.g., weather derivatives).
This is a guide to Derivatives in Finance. Here we also discuss the introduction and types of derivatives in finance along with examples and uses. You may also have a look at the following articles to learn more –