Everything You’ve Ever Wanted to Know About Derivatives

The capital markets and broader economy hum when a number of components work together in harmony. Risk and reward are some of the most basic principles that underlie every transaction that takes place in the capital markets. One mechanism that enables investors to manage their risks is derivatives.

Today, many companies use derivatives to protect themselves against challenges that are part of running a business. Financial institutions also use derivatives to hedge their exposure for things like credit risk so they can lend more money to more borrowers.

Here are a few key facts about what derivatives are, what they do and how they are being used today.

Simply put, a derivative is “a financial contract whose value is based on, or derived from, a traditional security (such as a stock or bond), an asset (such as a commodity) or a market index.” Derivative instruments include options, futures and swaps. Some derivatives are traded on exchanges or electronic facilities, while others are privately negotiated between two parties. The latter are known as “over the counter” derivatives or “OTC” derivatives.

Some people might assume that the only beneficiaries of derivative investments are financial firms. But many non-financial organizations, like manufacturing companies that conduct business internationally participate in derivatives markets. Some firms use derivatives to protect customers from unexpected market shifts such as sudden changes in foreign currency exchange rates.

Consider, for example, a large electric utility, like the one you pay once a month to make sure your lights stay on. That company can use derivatives to hedge the risk of a sudden shift in the price of fuel that it uses to produce electricity. Over a period of time, this enables your electric company to keep steady the cost of production, which, in turn, helps keep your budget on track.

If you have homeowner’s insurance, you pay a premium to protect your house from risks such as a fire. In the event you do not experience a loss, you “lose” the policy premium you paid for the insurance. If you do experience a covered loss, you are protected. Options work in a similar way.

An option contract gives the buyer the right (but not the obligation) to buy or sell an underlying asset at a specified price and time. The buyer of an option is also known as the holder. The seller of the option, also known as the writer, has the obligation to buy or sell the aforementioned underlying asset at the same specified price and time.

For example, if an investor owns shares of XYZ Company and is concerned that the price may go down, the investor could buy a “put” option, which is the right to sell those shares in the future at an agreed upon price. If the share price does go down during the agreed upon time period, the option has protected the investor from the decline in price; if the share price does not go down, the option becomes worthless.

Futures, unlike options, create an obligation to buy or sell a certain asset at a specified price and time. Futures trade on exchanges and create obligations for some time in the future, typically ranging from months up to a year or so.

The use of futures to manage risk happens frequently in American farming. Let’s take an orange farmer in Florida, for example. This orange farmer cannot predict what his orange crop will yield. To manage this risk, the farmer could enter into an agreement to sell oranges (that are yet to be harvested) at an agreed upon price and time in the future. In this case, the farmer is able to protect himself from future fluctuations in the market and gets an upfront payment for the oranges regardless of the future price.

Swaps, like futures, create an obligation; unlike futures, however, swaps are ongoing obligations over a period of years and in many cases involve the periodic exchange of cash flows over time.

Swaps are an effective way to manage risk. For example, ABC Company sells products in the U.S. for which it earns U.S. dollars, although the products are sourced overseas. The company is concerned that the foreign currency cost of its inputs will rise relative to its U.S. dollar income. ABC Company could use a swap to hedge the foreign exchange risk inherent in its business with a swap that fixes the foreign exchange rate of a certain amount of cash flow over an agreed period of time.