Derivatives

Overview

A derivative refers to a financial contract whose value is derived from the price of an underlying asset such as a share, bond, commodity, etc, rather than having an independent value of its own. 

Purpose

Derivatives serve three main purposes for individuals and firms in the financial sector. 

Hedging: An investor can use derivatives to protect against an adverse price move in something that they already own or are exposed to, thus offsetting potential dangerous losses. 

Trading: Due to speculation, a trader can take a position purely to profit from a predicted price move. 

Arbitrage: A money-making method in which traders exploit small, temporary price discrepancies between similar markets to make money on the difference in prices. 

Main types

There are three major categories of derivatives which are futures, options, and swaps, which each work differently and have their own uses, so will be covered in their own individual articles. 

Regulation

After the 2008 financial crisis, regulators started pushing heavily for standardised derivatives to be centrally cleared through a clearing house rather than traded privately between two parties which reduces the risk that one party’s default will cascade through the entire financial system. In the UK and EU, this is the framework that is set out under the European Market Infrastructure Regulation (EMIR).

Risks

Derivatives can be extremely risky as they often only require a small upfront margin relative to the size of the position that they can control thus holding a huge leverage risk which means losses can far exceed the initial amount that’s put down. 

They can also carry counterparty risk which is that if the other side of the contract is failed to be honoured it can have catastrophic consequences such as the near collapse of insurance giant AIG during the 2008 crisis.