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What are derivative contracts?

TL;DR

  • Options, forwards, futures and swaps are types of derivative instruments

  • Derivative contracts track the performance of an “underlying” asset.

  • Majority trade in the OTC markets but some trade on standardized exchanges

  • Good source of return and portfolio diversification

  • High risk and highly unregulated


What are derivative contracts?


Derivative contracts began in the agricultural industry where one party to a contract agreed to sell goods to the other party at a specified price on a specific date.


Derivative contracts allow parties to transact an option of a security, either immediately or at a later date. The security is referred to as the “underlying” as it drives the value of the derivative contract. This allows holders to hedge risk (in terms of price fluctuations) and accelerate returns. Similar to alternative investments, derivative contracts are also leveraged, so as high as the gains can be, the losses can be deep too.


Most derivatives are traded in the over-the-counter market but as mentioned above, some options and futures are traded only on standardized exchanges. This allows the clearing house to guarantee the transaction occurs.


Benefits and drawbacks


By investing in derivative contracts, the holder can “hedge” against the underlying asset i.e. gain protection against the price moves of the asset.


For example, if a producer of sugar likes the price today and is worried that it would go down in a few months, he can hedge his position by selling sugar at today’s price, thus effectively betting that the price would fall tomorrow . This transaction would protect the producer from any fluctuation in price in the future. A speculative trader would take the other side of the bet if she believed that the price of sugar would instead increase in the future.


In another example, interest rate swaps allow users to lock in favorable rates relative to the interest rate from directly borrowing.


Did you know that credit-default swaps, a type of derivative contract, led to the collapse of financial institutions and eventually the Global Financial Crisis? The volatility involved in trading derivatives is very high, exposing investors to potentially large losses. The unregulated nature of derivatives also make them very complex and difficult to fairly value. As a result, these contracts are made available only to institutional or experienced investors. In addition to downside risk, there is a chance that the counter-party you are doing business with might default on their payment.