Derivatives are another major type of financial instrument. We introduced two other major types in our earlier articles on fixed income and equities. As the name implies, the value of a derivative is derived from something else, whether an index, interest rate, debt, or physical asset. In terms of size, derivatives dwarf equities and fixed income instruments. An exact size is difficult calculate, but it is estimated to be twice the size of the fixed income and equity market combined. In this article, we will provide a brief overview of the most common forms of derivatives: futures, swaps, and options.
A future is a contract to buy or sell a specific asset at a particular future date and price. Futures are commonly used to hedge (reduce risk) against possible price movements. A seller that enters into a futures contract would have a guaranteed sell price, insulating them from possible drops in price. Likewise, a buyer that enters into a futures contract would have a preset buying price that protects them from a price increase.
One risk with futures contracts is that one party will default on their obligation. To help protect against this, futures exchanges require each party to put up an initial amount of cash, referred to as the margin. The margin amount is usually a percentage of the value of the contract. The margin is maintained throughout the life of the futures contract, and balanced daily to account for any gain or loss due to price movement. For example, if a seller enters a futures contract and the price of the asset goes down, the seller makes money since they are able to sell at a higher price than they would otherwise. The amount they gain would be transferred from the buyer’s margin account into the seller’s margin account. If the next day, the price of the asset goes up, money would be transferred back into the buyer’s account since they have now gained from the higher price. In this way, the gains and losses by both parties is protected since they are accounted for by the money in the margin accounts. If one party defaults, the other party will be compensated from the margin accounts and their losses will be minimized.
Futures contracts are also commonly used for speculation. An investor can enter into a futures contract as a buyer and hope that the price of the asset goes up. If so, they can sell the asset for a higher price than they purchased it for. However, there is always the risk that the price will go down and they will be forced to buy an asset for more than market price. An investor can also speculate on futures as a seller, where they hope that the price of the asset goes down. Then they will be able to sell an asset at a higher price than market. However, there is once again a risk that the price will move in the opposite direction, and the investor will lose money.
As the name implies, swaps are a contract between two entities where they agree to exchange cash flows. A swap can be advantageous if the parties have differing levels of access to a particular financial instrument, currency, or commodity. For example, a company may have access to desirable variable interest rates but not to desirable fixed rates. Meanwhile, another company may be in the opposite situation, having access to desirable fixed interest rates, but not variable rates. These two companies can agree to a swap where they each take out the loan that they have best access to, and then swap interest payments. The companies do not actually trade loans, instead they agree to trade the cash flows on those loans.
In a way, a swap is simply a contract of payment between two entities. An interest rate swap is the most common type of swap, but there are many others including currency swaps, commodity swaps, and credit swaps.
Swaps will likely not be encountered directly by an average individual investor. However, they are important since they make up a large piece of the world’s financial derivatives. Credit swaps in particular played an important role in the Financial Crisis as highly leveraged credit swaps led to the collapse/default of many large banks.
An option is a contract that gives an investor the right to buy or sell a specific asset at a particular price. The right to buy or sell an asset is valid for a set period of time, after which the option expires. The major feature of an option is that the option holder does not have to exercise their right. The final purchase or sale of the asset is optional for the investor that bought the option, hence the name. In exchange for this right to buy or sell, the investor pays the option creator a fee or premium.
The two types of options are calls and puts. An investor who holds a call option has the right to buy an asset for a set price. If the price of the asset goes up before the option expires, they can buy the asset at the price in the contract and sell for the (now) higher market price. A put is the opposite of a call, a holder of a put option has the right to sell an asset for a given price. If the price of the asset goes down before the option expires, an investor can buy the asset at the (now) lower market price and sell for the higher option price.
The earlier paragraph was about investors who hold a put or call option. There are also investors who create or write the options and then sell them to earn the premium. These investors are in a different situation from the option holders in the previous paragraph because they must fulfill the option that they wrote, if it is exercised. A writer of a put option is forced to buy the asset at the agreed price, so if the market price is drops, they will end up overpaying for the asset. A writer of a call option is in a particularly risky position as they are exposed to theoretically unlimited risk. They are forced to sell an asset for a particular price; but if they do not already own the asset then they will have to buy it from the market first. They are then forced to sell it at the price specified in the options contract, which may be a small fraction of the market price.
To further complicate things, options are traded on a market. The cost of a put or call is based on the supply and demand of options on an exchange. As expected, if the price of the asset moves favorably, the cost/price of the option will also increase. So a profit can be realized by simply buying and selling the options themselves, and not the underlying asset. In fact, most option holders choose to sell their options on the exchange instead of exercising them.
The main uses of options are hedging and speculation. With all investments there is an element of risk, but options are worthless if the price of the asset does not move in a favorable direction. So when speculating with options you are at risk of losing the entire amount you spent if you do not correctly predict the direction of price movement and the timing of the movement as well. Because of the high risk, options trading should be undertaken by experienced investors.
As we’ve emphasized in the past, we believe that the best investment for the average person is in Exchange Traded Funds (ETF's). These investments are relatively low cost, low maintenance, and carry low to moderate risk. These investments are also not derivatives, and as a result most of our investors will not need to invest in derivatives directly.