A derivative or “derivative financial instrument” is an agreement between two or more parties that provides certain mutual actions with the underlying asset subject due to certain conditions. As a rule, we are talking about buying and selling, which means making a profit, depending on the fluctuation in the value of the underlying asset.
Such assets may include stocks, bonds, commodities, cryptocurrencies, interest rates, and even market indices. And all this is acquired / sold through specialized brokerage houses. The advantage of exchanges is that they are equipped with fairly clear and precise regulatory tools, while derivatives contracts are formatted and standardized. As for the OTC, which make up a substantial part of the derivatives market in total, they are not protected against counterparty risk. That means - the refusal of one of the parties to participate in the transaction, known as defaulting.
The main purposes of use
Derivative financial instruments are used both to hedge their position and to speculate on the direction of movement of the price of a resource. Derivatives were initially used in the framework of international trade to smooth out fluctuations in the exchange rate. Now their application is more diverse since there are contracts based on such non-financial factors as the total rainfall and sunny days in the region.
Let's consider a simple example. There is an investor from Europe whose accounts are nominated exclusively in euros. He decides to acquire shares in some American company. Of course, in dollars. The so-called "currency risk" is included - possible losses due to fluctuations in the relative euro / dollar exchange rate. Since even with an increase in the value of the shares of the acquired company, a fall in the rate can offset this profit.
And in order to hedge this risk, the investor acquires a currency derivative in order to fix the rate for a certain period. Which specific instrument will be used - currency futures or swaps - depends on the situation.
Speculators can purchase derivatives that grow, for example, in price, along with the euro. At the same time, they do not even need to own the underlying asset in order to have a profit from its price movement.
Main forms
Derivative financial instruments are a growing market, so there are products on it that correspond to almost any needs or goals of investors.
Futures
An official exchange contract between the two parties on the supply of goods on a strictly defined date at a predetermined price. A great way to hedge risk, because both parties are required to complete the transaction after its expiration.
A simple example. There is a buyer who wants to buy 1000 barrels of oil at a price of $ 66 each. He concludes a futures contract for a certain period, and at the end of it - receives his goods at the announced price, even if the price of oil has risen. So he hedged his risk. The opposite situation is also possible - in any case, the buyer is guaranteed to need oil by a certain date - he hedges the risk of supply disruption using futures. And the seller, in turn, hedges the risk of an excessive drop in oil prices.
It is also possible that both the seller and the buyer are speculators with the opposite opinion about the direction of the course. And the buyer is not going to use the purchased product, but only sell it further at a favourable price. Moreover, if they are not satisfied with the trends in the market, then everyone can break the futures, paying a substantial amount in compensation.
In any case, a very small part of the futures ends in a real asset purchase. Most often, instead of a product, its cash equivalent is accepted. Therefore, there is such a thing as interest rate futures, stock indices and even volatility futures.
Forwards
They are very similar to futures because they also guarantee mutual fulfilment of obligations between the seller and the buyer. But they are traded separately from the exchange - exclusively between two partners. This allows you to better adjust the conditions, sizes, terms and interest rates, but seriously increases the counterparty’s risk, moreover, for both parties.
Counterparty risk - a situation where one of the parties is not able to fulfil obligations at the time of completion of the contract. Simply put, if one party is insolvent, the other will not be able to close the contract on its own. Plus, a situation is possible when for the implementation of one forward you have to make new ones with other representatives, which further increases the risk. Speculation in such conditions can be extremely dangerous.
Swaps
A popular financial instrument, which is essentially a “contract exchange”. Often used to switch between loans with fixed and variable interest rates.
A simple example. There is company X, which borrowed a million dollars and pays a loan at a variable interest rate of 6 percent. The company is afraid of a further increase in rates and cannot normally interact with other lenders who do not want to work on such conditions.
Then company X can create a swap with company Z, which agrees to exchange payments at a variable rate of 7 percent of the base capital for a payment of 7 percent on it, but at a fixed rate. To make this happen, company X at the beginning of the swap pays company Z the same 1% of the difference between the swap rates. Now X can enter into other contracts, because formally it is no longer associated with a variable rate loan.
If interest rates suddenly fall, for example, to 5 percent, then company X will have to pay this difference. If they increase, the difference will be paid by company Z. In any case, no one gets profit here - they simply “convert” one loan to another.
There are swaps that work with the exchange rate, with the risk of default on loans, with potential defaults on mortgage bonds and much more. The problem is that such derivatives are also associated with counterparty risk, which in 2008 led to the largest credit crisis.
Derivatives are an extremely effective and convenient tool for an experienced investor. They allow you to fix prices, hedge adverse changes in interest rates, significantly reduce risks, achieve significant profits, including with borrowed funds. In addition, they seriously facilitate portfolio diversification, since more than one agreement with different conditions can be concluded for one underlying asset.
At the same time, it is extremely difficult to evaluate the success of derivatives, since they are tied not only to the base price of another resource, but also to unpredictable factors. In addition, the closer the deal closes, the more dangerous are any random fluctuations in prices. And very few investors can really calculate the profitable ratio between the value of the derivative and the value of the underlying asset.
Also, such contracts are vulnerable to market sentiment. There could be a situation where the supply and demand factor will lead to a decrease in the value of the derivative, regardless of the price of the underlying resource.
As for the possibility of attracting borrowed funds, this is both a plus and a minus. Profit can be increased, but the possible losses too.