Derivatives
What is a derivative?
A derivative is a financial contract between parties. It has a value based on an underlying asset, like a market index or commodity.
Derivatives are usually used to access a market or an asset in hard-to-reach areas. They can also be used to trade against risk. This can be either aiming to reduce risk of loss by ‘hedging’ or attempting to increase risk to earn a higher possible reward through ‘speculation’.
Professional investors and fund managers can use advanced investing techniques, and derivatives are common amongst these. Some derivative types can be traded on exchanges such as the London Stock Exchange (LSE) but others are over-the-counter (OTC) where they don’t meet the listing requirements for exchanges and are dealt via a broker direct with a seller.
What are the types of derivatives?
There are four main types of derivatives – futures, forwards, options and swaps.
Futures
A futures contract is an agreement to buy and deliver at a fixed price at a fixed point in the future. These types of contracts are usually used to lower the risk of fluctuating prices – airline companies can ‘lock in’ the price of fuel in advance.
Futures trade on a stock exchange with a live market price.
Forwards
Forward contracts are like futures contracts, but there are some small differences. Forwards trade over-the-counter (OTC) rather than on an exchange. They’re tailored rather than standardised, offering more flexibility to adjust the terms of the contract to whatever needs are required.
Forwards still have trade dates in the future, like futures contracts, but they can also carry more risk. Parties in a forwards position can add further parties to the contract. You could end up owing multiple parties following the term of a forward contract. If one party can no longer fulfil the contract, the other parties might not be able to get their money back. This is called counterparty risk.
Options
An options contract is the right to, but not the obligation, to buy an asset at a fixed point in the future. The option to leave the contract can be either throughout the term of the contract, or when it expires.
The contract still needs to be fulfilled. But depending on how the price has moved, an option can be rendered worthless. If the price is above the agreed price at expiration, the option is worthless, and the seller keeps the premium.
Swaps
A swap is an agreement to exchange something for a specific period of time. For example, two parties enter into a swap agreement on interest rates – known as an interest rate swap. This is where one party would swap a fixed rate of interest for a floating rate of interest, and vice versa.
Both parties agree a date the swap agreement ends, a maturity rate, as well as the value of the contract. By swapping, the two parties changed their interest method based on what they feel could happen to interest rates in the future.
Options are typically traded over-the-counter (OTC) – they don’t meet listing requirements for most exchanges. Swaps are used to hedge or speculate on changes in underlying prices, such as interest rates.
What are underlying assets of derivatives?
Underlying assets can vary from shares, bonds, commodities like gold or silver, currencies, interest rates and market indices. Investors can use derivatives to gain exposure to them without holding the underlying asset themselves.
What does it mean for investors?
Derivatives sometimes have a place in the market for more advanced investing strategies used by companies or professional investors like fund managers. However, we think the downside risks that come with derivatives ultimately aren't worth the potential gains for retail investors – particularly when you take fees into account.
Using derivatives as part of your strategy is time intensive. Unless you've got buckets of time and access to high-tech trading technologies, it could be better to position your portfolio towards long-term investments.
Related topics
Read more related glossary terms
Quantitative Easing
Quantitative easing (QE) is a monetary policy tool where central banks purchase government bonds or other financial assets to increase money supply and stimulate economic activity. This is often referred to as ‘printing money’.
Yields
A yield measures any income from an investment over a set period of time, such as dividends from shares or interest from bonds.