What is a Derivative and how do they work?

Last Updated on 30 April 2021 by Dan

Hello everyone! Today I thought I’d talk about derivatives. They’re something that pop up in the news occasionally (particularly during the financial crisis) and generally get described outside the financial industry as difficult and hard to understand.

Here’s the truth though – whilst pricing and understanding the market for derivatives can definitely be complex, the actual underlying products are really pretty simple in concept.

So today I’m going to demystify them and explain what they are, and what their commercial purpose might be!

As ever – our normal note that we take care with what we write on this site but it is not official “financial advice” and whatever investments and savings you enter need to be right for your circumstances. We always suggest doing your own further research. If you’re in doubt about anything, it’s worth consulting a regulated and reputable financial advisor who can provide tailored advice built for you.

Investing in Derivatives

I do want to start with a note that for nearly all retail investors I would never suggest directly investing in derivatives and leaving it to professionals – this article is meant for knowledge purposes only and explain how companies/investors use these instruments.

To use derivatives sensibly requires careful construction of your position to manage and understand the upside and downside risk, as you can expose yourself quite easily to heavy and in some cases unlimited losses, particularly with options! They sound quite simple when I’m explaining things below, but in practice these are often actually traded in large quantity, meaning a small price movement can have a very large effect on an investment.

Unless you feel you know exactly what you’re doing, I suggest steering clear – and I’d suggest being cautious and taking advice on any investment products which reference derivatives.

What is a Derivative?

It can be a variety of financial products, the key thing is that the price is influenced by something else. Before your head starts spinning let me explain further……

I want to buy a barrel of oil (just a purchase) but I want to buy it 12 months from now (add complexity).

Adding that second part makes it a derivative – where we take something simple like buying oil and put a layer of financial engineering on top.

The price of the end product will be mainly influenced (or in maths speak, derivative) of the price of oil, but but there’s a different in the cost because we have to consider for the implications of you getting it 12 months from now (and the fact the market for oil might be different at that point).

Exactly what that financial engineering layer does depends on the type of derivative we enter into. So without further ado…..

Types of Derivatives:

Let’s walk through some of the different types of derivatives which are out there:

What are Futures and Forwards?

If I buy a future or forward, it’s the same concept as locking in a price – I agree to take something off your hands in six months for a price we agree now.

This could work in my favour or not – let’s take a worked example.

I’m an airline, and I’m looking to buy some jet fuel for my planes. Based on my industry knowledge, I think there might be some supply shortages later in the year so whilst it’s trading at £50 a barrel now, I’ll agree to buy it in a year at £60.

A year passes. If the price of a barrel of fuel goes up to £70, excellent – there’s an obligation to sell it to me at the lower agreed price of £60. If the price didn’t increase at all, I’m stuck paying a more expensive price for the fuel than the present market value.

Now we’re talking about financial gains and losses there on these which is the speculative side of these products but for businesses they serve a much more practical purpose. Let’s stick with our airline example:

  • You avoid storage costs by agreeing a future delivery. In the above example the fuel is cheaper in the present day that what I’m agreeing in the contract, so you may wonder why I’m agreeing to pay a higher price in a year rather than taking it today. They key is that if I buy it today I have to store it and keep it secure. When you’re talking the volume of fuel that a carrier like a British Airways needs, that’s a very significant additional cost – so there’s significant benefit in itself in later delivery.
  • It help price smooth. As I know what price I’m paying for the fuel, I know what it will cost to operate my flight and can price tickets accordingly. This helps the market run more efficiently, knowing that even if a price shock to jet fuel happens it won’t affect your business short term, and you don’t have to “over-price” the ticket out of fear the cost of running the flight could significantly increase.

That latter point is really key – most derivatives have their roots in agricultural markets and this is a classic example. Farmers were in a position where they might be facing “feast or famine” depending on if the year was a good or bad harvest – agreeing sales of their produce in advance meant that income was a surer thing, even if they may have done better or worse if they sold at whatever the present day price way.

You can sell and buy forwards/futures – the value of the forward will depend on the market has moved over time in reality (relative to what the future contract states).

What’s the difference between a Future and Forward?

The “what they do” in respect of setting up an agreement to buy at a future price is the same.

A future is a standardised contract which is built with easy and common trade terms so “1000 barrels of WTI Oil”. As a result it’s tradable on an exchange (where lots of buyers and sellers sit) as many companies will be set up to accommodate the standard terms.

A forward is more customisable and you’d usually (but not always, commodities tend to be an exception) trade it bilaterally (I.E with a specific person) – so “I agree with JP Morgan for a 5 month contract for 726 barrel of specifically graded oil”.

Owing to it’s replicable nature and sitting on the exchange, a future is generally more easily tradable.

A quote screen of derivatives

What are Swaps?

With a swap, I agree to swap one type of cash flow for another one type of cash flow that suits my needs better.

There’s a nice relatable example of this in the form of a mortgage – let’s say I’ve got a variable rate mortgage, and I’ve got a friend with a fixed rate mortgage.

I’ve suddenly got a period coming up I need to budget carefully, and I’d rather be on a fixed mortgage to know exactly what I want to pay. My friend on the fixed rate mortgage doesn’t care about the variability, he’s rather have slightly cheaper variable rate and accept the risk it might go up in future. So we swap, with one of us agreeing to move from a “fixed” to a “floating” interest rate and vice versa and you keep swapping on a continuous basis.

This is commonly based on interest rates, but anything can be a swap. Taking another example, if you’ve got two companies who have assets generating cash, and one in dollars and one in pounds, they might engage in a currency swap to fund their local operations.

Swaps can get complex, but at core these are nothing more than harking back to playground days, where you swapped a football sticker/Pokemon card/collectable of the day because your friend had something you wanted, and you had something they wanted – you’re just agreeing to keep swapping each time over a period of time.

What are Options?

An option is where I pay a small premium for the right but not the obligation (i.e, I give myself the option) to buy or sell a stock at a specific price at a specific date, and pay a small premium for the right to do this.

If I’m buying it’s basically a future I can change my mind on. Let’s stick with the example above – a barrel of oil is presently £50, and I take an option to buy it at £60 in a year. I pay a small premium of £2 for doing so.

In practice, oil stays at £55 in this case I don’t take the option (if it’s not in my favour it’s known as being out-of-the-money) and I lose the premium.

In an alternative world, oil goes up to £70 a barrel. I use to use the option as the option allows me to buy it at £60 (I’m therefore in-the-money) and I still pay the premium, so I’m £8 a barrel better off that I would have been.

Doing something of this variety where you’re taking the option to buy at a particular price is known as a “call” option.

Being on the other side of the transaction and agreeing a right to sell at a particular price is a “put” option.

The price of an option during it’s lifetime depends on a number of underlying factors that tie back to how likely it is the option will or won’t be used – like how variable the price of the underlying product is or how close the option might be to triggering. As a result they’re rather tricky to price.

Any questions on Derivatives?

I hope this clears up a tricky bit of finance for you but if your head is still in a spin after reading, please do ask any questions in the comments below!

And that’s it!

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