Karthikeyan Sriraman

Derivatives are financial contracts that derive their value from an underlying asset, such as stocks, bonds, commodities, currencies, interest rates, and market indices. Banks offer a variety of derivative products to their customers, including futures, forwards, options, and swaps. These products can be used for a variety of purposes. 

While more prevalent in the modern era, derivatives have a long history, with origins tracing back centuries. One of the earliest examples is rice futures traded on the Dojima Rice Exchange in the 18th century. Over time, the derivatives market has evolved significantly, expanding with products to fit nearly any need or level of risk tolerance. A key function of derivatives is their ability to transfer risk from those who seek to avoid it to those who are more willing to accept it in anticipation of potential rewards.

How Derivative Products Work

Each derivative product has its own unique characteristics, but they all share some common features. Here’s a closer look at how each type of derivative product works:

• Futures Contracts: A futures contract is a standardized agreement traded on an exchange, where two parties agree to buy or sell an asset at a predetermined price on a specific future date. These contracts are commonly used for hedging against potential price fluctuations or for speculation. For example, an airline might use futures contracts to lock in the price of jet fuel, protecting themselves from potential price increases.
• Forward Contracts: Similar to futures contracts, forward contracts are agreements to buy or sell an asset at a predetermined price on a future date. However, unlike futures, forward contracts are not standardized and are traded over-the-counter (OTC). This allows for greater flexibility in terms of contract size and maturity date. For example, a multinational corporation might use a forward contract to hedge against currency fluctuations when receiving payments in a foreign currency.
• Options Contracts: An options contract provides the buyer with the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a specified price (strike price) on or before a certain date (expiration date). Options can be traded both on exchanges and OTC. For instance, an investor who believes a stock price will rise significantly might purchase a call option, allowing them to buy the stock at a lower price even if the market price surges.
• Swap Contracts: Swap contracts involve an agreement between two parties to exchange cash flows based on different financial instruments. These are primarily OTC transactions. Interest rate swaps are a common type, where one party might exchange a stream of fixed-interest payments for a stream of floating-interest payments. For example, a company with a variable-rate loan might enter an interest rate swap to convert it to a fixed-rate loan, providing greater certainty in their financial planning.

Examples of Derivative Products

Derivative Type	Description	Example
Forward Contract	An agreement to buy or sell an asset at a certain price on a certain date. Traded OTC.	A company agrees to buy 1,000 barrels of oil at $70 per barrel in six months.
Futures Contract	A standardized agreement to buy or sell an asset at a certain price on a certain date. Traded on an exchange.	An investor buys a futures contract to sell 1,000 bushels of corn at $5 per bushel in three months.
Option Contract	An agreement that gives the buyer the right, but not the obligation, to buy or sell an asset at a certain price on or before a certain date.	An investor buys a call option on a stock that gives them the right to buy 100 shares of the stock at $50 per share in six months.
Swap Contract	An agreement between two parties to exchange cash flows. Predominantly traded OTC, but some are traded on exchanges.	A company enters into an interest rate swap to exchange its variable-rate debt for fixed-rate debt.

Scenarios in Which Derivative Products are Offered

Derivative products are offered in a variety of scenarios, including:

Risk Management with Derivatives:

• Hedging: Companies use derivatives to hedge against a variety of risks, including interest rate risk, currency risk, and commodity price risk. For example, a company that is exposed to rising interest rates could use an interest rate swap to convert its variable-rate debt to a fixed-rate obligation. Importers, exporters, and companies with significant overseas operations use derivatives to manage exchange rate risk.
• Protecting Lenders: Derivatives can also be employed to protect lenders from the risk of borrowers defaulting on their obligations, such as through credit default swaps.
• Mitigating Weather-Related Risks: Businesses in sectors like agriculture, natural gas, electricity, and oil utilize derivatives to mitigate the risk associated with adverse weather conditions. For example, a farmer could use weather derivatives to protect their crops from potential losses due to drought or excessive rainfall.

Speculation: Investors use derivatives to speculate on the price movements of assets. For example, an investor who believes that the price of gold will go up could buy a call option on gold futures. If the price of gold goes up, the investor will profit from the option. Speculation in derivatives can range from simple directional bets to more complex strategies involving volatility or arbitrage.

Generating Income: Banks use derivatives to generate income. For example, a bank could sell a put option on a stock index. If the stock index stays above the strike price, the bank will keep the premium that it received for selling the option. Banks also generate income by acting as market makers in derivatives, providing liquidity and facilitating trades for their clients.

Accessing New Markets: Derivatives can be used to access new markets. For example, an investor who wants to invest in a foreign market but faces restrictions could use a non-deliverable forward (NDF) to gain exposure to that market’s currency.

Given the diverse applications of derivatives, it’s no surprise that a wide range of users participate in these markets.

Users of Derivative Products

A wide range of users utilize derivative products, including:

• Corporations: Corporations use derivatives extensively for various purposes. They use interest rate swaps to manage their debt obligations and currency swaps to hedge against foreign exchange risk. Commodity producers, such as mining companies or oil and gas companies, use futures contracts to lock in prices and manage their exposure to commodity price fluctuations.
• Institutional Investors: Institutional investors, such as pension funds, insurance companies, and hedge funds, use derivatives to manage their portfolios and achieve specific investment objectives. They might use index futures to gain broad market exposure or options to generate income or protect their portfolios from downside risk.
• High-Net-Worth Individuals: High-net-worth individuals use derivatives to speculate on price movements and to hedge against risk in their personal portfolios. They might use options to participate in the potential upside of a stock while limiting their potential losses or use futures contracts to gain exposure to commodities or currencies.

Potential Risks in Derivative Products

While derivatives offer many benefits, it’s important to be aware of the potential risks involved, including:

• Counterparty Risk: Counterparty risk is the risk that the other party to a derivative contract will not fulfill its obligations. This risk is particularly relevant for OTC derivatives, which are not traded on an exchange.
• Market Risk: Market risk is the risk that the value of a derivative will decline due to changes in market conditions. This can result in significant losses, especially for leveraged positions.
• Liquidity Risk: Liquidity risk is the risk that it will be difficult to sell a derivative contract. This risk is particularly relevant for OTC derivatives, which are not traded on an exchange.
• Complexity and Valuation: Beyond the risks mentioned above, it’s crucial to acknowledge some inherent downsides to derivative use. These instruments can be complex to understand and value, their prices are influenced by supply and demand factors, and they can be vulnerable to shifts in market sentiment.
• Systemic Risk: It’s important to recognize that the complex web of derivative contracts among financial institutions can contribute to systemic risk. The failure of one major player in the derivatives market could potentially trigger a cascade of defaults, impacting the stability of the entire financial system.

Summary

Derivative products are complex financial instruments that can be used for a variety of purposes, from managing risk and accessing new markets to speculating on price movements and generating income. The derivatives market continues to evolve, with new products and applications emerging to meet the changing needs of investors and corporations. It also plays a significant role in the broader financial system, contributing to price discovery and market efficiency. 

However, it is important to understand how derivative products work and the potential risks involved before using them. These risks include counterparty risk, market risk, liquidity risk, and the inherent complexity of these instruments. Their interconnectedness can also contribute to systemic risk, highlighting the importance of responsible use and robust risk management practices.

By carefully considering the risks and benefits, investors and corporations can use derivatives strategically to achieve their financial goals and navigate the complexities of the financial markets.