Financial Derivatives: Definition, Types, Risks

A derivative is a financial contract that derives its value from an underlying asset. The buyer agrees to purchase the asset on a specific date at a specific price. 

Derivatives are often used for commodities, such as oil, gasoline, or gold. Another asset class is currencies, often the U.S. dollar. There are derivatives based on stocks or bonds. Others use interest rates, such as the yield on the 10-year Treasury note. 

The contract's seller doesn't have to own the underlying asset. They can fulfill the contract by giving the buyer enough money to buy the asset at the prevailing price. They can also give the buyer another derivative contract that offsets the value of the first. This makes derivatives much easier to trade than the asset itself.

Derivatives Trading

In 2019, 32 billion derivative contracts were traded. Most of the world's 500 largest companies use derivatives to lower risk. For example, a futures contract promises the delivery of raw materials at an agreed-upon price. This way, the company is protected if prices rise. Companies also write contracts to protect themselves from changes in exchange rates and interest rates. 

Derivatives make future cash flows more predictable. They allow companies to forecast their earnings more accurately. That predictability boosts stock prices, and businesses then need a lower amount of cash on hand to cover emergencies. That means they can reinvest more into their business.

Most derivatives trading is done by hedge funds and other investors to gain more leverage. Derivatives only require a small down payment, called “paying on margin.”

Many derivatives contracts are offset—or liquidated—by another derivative before coming to term. These traders don't worry about having enough money to pay off the derivative if the market goes against them. If they win, they cash in.

Exchanges

A small percentage of the world's derivatives are traded on exchanges. These public exchanges set standardized contract terms. They specify the premiums or discounts on the contract price. This standardization improves the liquidity of derivatives. It makes them more or less exchangeable, thus making them more useful for hedging.

Exchanges can also be a clearinghouse, acting as the actual buyer or seller of the derivative. That makes it safer for traders since they know the contract will be fulfilled. In 2010, the Dodd-Frank Wall Street Reform Act was signed in response to the financial crisis and to prevent excessive risk-taking.

The largest exchange is the CME Group, which is the merger of the Chicago Board of Trade and the Chicago Mercantile Exchange, also called CME or the Merc. It trades derivatives in all asset classes.

Stock options are traded on the NASDAQ or the Chicago Board Options Exchange. Futures contracts are traded on the Intercontinental Exchange, which acquired the New York Board of Trade in 2007. It focuses on financial contracts, especially on currency, and agricultural contracts, principally dealing with coffee and cotton.

The Commodity Futures Trading Commission or the Securities and Exchange Commission regulates these exchanges. Trading Organizations, Clearing Organizations, and SEC Self-Regulating Organizations have a list of exchanges.

Types of Financial Derivatives

The most notorious derivatives are collateralized debt obligations. CDOs were a primary cause of the 2008 financial crisis. These bundle debt, such as auto loans, credit card debt, or mortgages, into a security that is valued based on the promised repayment of the loans.

There are two major types: Asset-backed commercial paper is based on corporate and business debt. Mortgage-backed securities are based on mortgages. When the housing market collapsed in 2006, so did the value of the MBS and then the ABCP.

The most common type of derivative is a swap. This is an agreement to exchange one asset or debt for a similar one. The purpose is to lower risk for both parties. Most of them are either currency swaps or interest rate swaps.

For example, a trader might sell stock in the United States and buy it in a foreign currency to hedge currency risk. These are OTC, so these are not traded on an exchange. A company might swap the fixed-rate coupon stream of a bond for a variable-rate payment stream of another company's bond.

The most infamous of these swaps were credit default swaps. They also helped cause the 2008 financial crisis. They were sold to insure against the default of municipal bonds, corporate debt, or mortgage-backed securities.

When the MBS market collapsed, there wasn't enough capital to pay off the CDS holders. The federal government had to nationalize the American International Group. Thanks to Dodd-Frank, swaps are now regulated by the CFTC.

Forwards are another OTC derivative. They are agreements to buy or sell an asset at an agreed-upon price at a specific date in the future. The two parties can customize their forward a lot. Forwards are used to hedge risk in commodities, interest rates, exchange rates, or equities.

Another influential type of derivative is a futures contract. The most widely used are commodities futures. Of these, the most important are oil price futures—which set the price of oil and, ultimately, gasoline.

Another type of derivative simply gives the buyer the option to either buy or sell the asset at a certain price and date.

Four Risks of Derivatives

Derivatives have four large risks. The most dangerous is that it's almost impossible to know any derivative's real value. It's based on the value of one or more underlying assets. Their complexity makes them difficult to price.

That's the reason mortgage-backed securities were so deadly to the economy. No one, not even the computer programmers who created them, knew what their price was when housing prices dropped. Banks had become unwilling to trade them because they couldn't value them.

Another risk is also one of the things that makes them so attractive: leverage. For example, futures traders are only required to put 2% to 10% of the contract into a margin account to maintain ownership. If the value of the underlying asset drops, they must add money to the margin account to maintain that percentage until the contract expires or is offset.

If the commodity price keeps dropping, covering the margin account can lead to enormous losses. The CFTC Education Center provides a lot of information about derivatives.

The third risk is their time restriction. It's one thing to bet that gas prices will go up. It's another thing entirely to try to predict exactly when that will happen. No one who bought MBS thought housing prices would drop. The last time they did was during the Great Depression. They also thought they were protected by CDS.

The leverage involved meant that when losses occurred, they were magnified throughout the entire economy. Furthermore, they were unregulated and not sold on exchanges. That’s a risk unique to OTC derivatives.

Last but not least is the potential for scams. Bernie Madoff built his Ponzi scheme on derivatives. Fraud is rampant in the derivatives market. The CFTC advisory lists the latest scams in commodities futures.

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