Understanding Derivatives

A derivative contract is a delayed-delivery agreement whose value is dependent upon (derived from) an underlying asset — and the holder of the derivative does not own that underlying asset. A useful analogy: an option to buy a flat is a derivative — you pay a fraction of the price for the right to buy, but you do not own the flat until you later pay the balance. The 'underlying' can be almost anything: weather, farm/agricultural outputs, metals, energy, financials (physical such as equity/bond/currency, or intangible such as an equity index, bond index or interest rate) and digital assets (cryptocurrencies, NFTs, CBDCs).

Derivatives serve three broad purposes: as hedging tools (an oil producer and an airline both stabilise their revenue and fuel cost); as directional bets by speculators (a small outlay controls a larger exposure — the leverage/gearing effect, so the potential gain can be a multiple of a direct investment if the bet is right); and as risk-management tools (e.g. a corporation uses interest rate futures to control rate exposure before issuing bonds; a pension fund uses index options to reduce equity risk).

There are two particularly important types of derivatives — options and futures — and most other derivatives can be created from these two basic building blocks, often by combining them with stocks, bonds, indices, commodities or digital assets. This is why derivatives are integral building blocks of structured products. The chapter discusses four contract types: Futures & Forwards, Options & Warrants, Swaps, and Contracts for Differences (CFDs).

Futures and forwards are contracts giving the obligation to buy (a 'call' contract) or sell (a 'put' contract) the underlying: in a specified quantity, at a specified price (the delivery/future price), on a specified future date (the delivery/settlement date). Settlement is by physical delivery or cash settlement (cash settlement is the only option when the underlying is intangible, e.g. an interest rate or index). In practice only about 2%–5% of contracts settle by physical delivery; most are settled in cash or by entering offsetting contracts. The holder of a futures/forward the contract on settlement date.