Derivative Instruments: A Beginner’s Guide

• Article photo, courtesy of CEPR

Derivative instruments, an integral part of modern financial markets, empower participants to manage their exposure to various risks. Whether you're trading bonds, equities, foreign currencies, or commodities, derivatives offer a critical mechanism for protecting your investments against adverse price fluctuations, interest rates, and exchange rates.

The history of derivatives dates back to the 19th century, particularly in the commodity markets. The Chicago Board of Trade (CBOT), established in 1848, introduced a platform where agricultural products like wheat and corn could be traded. This enabled farmers and merchants to lock in prices well before harvest, providing much-needed stability and predictability. Over time, the use of derivatives expanded into financial markets, including stock indexes, foreign exchange, bonds, and interest rates. By the late 20th century, these instruments gained tremendous traction and became essential tools in financial strategies.

But what exactly are derivative instruments, and why do they matter? Here's a concise definition to clarify the concept:

What Are Derivatives?

A derivative is a financial contract whose value is derived from the performance of an underlying asset, such as stocks, bonds, commodities, currencies, or interest rates. The derivative's price is influenced by fluctuations in the value of the underlying asset.

Derivatives themselves can be highly versatile, used for speculation, risk management (hedging), arbitrage, or even engineering specific financial positions.

Types of Derivative Instruments

The traditional purpose of derivative instruments is to provide an important opportunity to manage against the risk of adverse future price, exchange rate, or interest rate movements. Derivatives come in various forms, each serving a unique purpose. However, the two basic derivative instruments are futures and forward contracts and options contracts.

1. Futures

   Futures contracts are standardized agreements created and traded on exchanges. These contracts require both parties to post an initial margin, and positions are marked-to-market daily to reflect current market values. If the equity in a position drops below a specified maintenance margin, an additional margin, known as variation margin, is required. A key benefit of futures contracts is the involvement of a clearinghouse, which guarantees that both parties will fulfill their contractual obligations.

Forwards

Forward contracts differ in several significant ways. Unlike futures, forward contracts are customized and traded over-the-counter (OTC), without the involvement of a clearinghouse. This means that parties to a forward contract bear counterparty risk — the risk that the other party may not fulfill their end of the agreement. Additionally, forward contracts are not marked-to-market, so there are no interim cash flows, and unwinding a forward contract before the settlement date can be challenging.

For both futures and forwards, profits and losses depend on price movements. A buyer of a futures contract profits if the price increases and incurs losses if the price decreases, while the seller experiences the opposite outcome. The same logic applies to forward contracts.

The theoretical pricing of futures and forwards can be derived through arbitrage. In cases where a futures or forward contract is overpriced, a cash-and-carry strategy can be used to exploit arbitrage opportunities. Conversely, for an underpriced contract, a reverse cash-and-carry trade can capture arbitrage profits. The fundamental pricing model asserts that the theoretical price of a futures contract equals the current market price of the underlying asset, plus the net financing cost. The net financing cost, also known as the "cost of carry," represents the difference between the financing cost and any cash yield provided by the underlying asset.

2. Options

   An option gives the buyer the right, but not the obligation, to either buy (in the case of a call option) or sell (in the case of a put option) an underlying asset at a predetermined price, known as the exercise or strike price, by a specified expiration date. The cost the buyer pays for this right is called the option price or premium.

   In the case of an American option, the buyer can exercise the option at any time up to and including the expiration date, while a European option can only be exercised on the expiration date. One key benefit for the buyer is that the maximum loss is limited to the premium paid, while the potential profit is unlimited. Conversely, the option seller (writer) has a capped profit, which is the premium received, but faces potentially unlimited downside risk.

   The price of an option is made up of two components: the intrinsic value and the time premium. The intrinsic value is the immediate economic value if the option were exercised, while the time premium reflects the amount by which the option price exceeds the intrinsic value, representing the additional value of holding the option until its expiration.

   Several factors influence the price of an option, including:

   • The current market price of the underlying asset
   • The strike price of the option
   • The time remaining until expiration
   • The expected volatility of the underlying asset (measured by standard deviation)
   • The short-term, risk-free interest rate over the option’s life
   • Anticipated cash flows or payments from the underlying asset

   Among these factors, the most challenging to predict is the expected volatility of the underlying asset, which is why valuing options is more complex than valuing futures or forwards. Several pricing models have been developed to determine the theoretical value of options, with the Black-Scholes model being one of the most well-known and widely used.

3. Swaps

   In a swap, two counterparties agree to exchange periodic payments over a specified period, with the amounts based on a notional principal that typically remains constant. The types of payments exchanged depend on the nature of the swap, and these contracts are commonly used to manage risk or take advantage of changing market conditions. Swaps frequently used by non-financial companies include interest rate swaps, currency swaps, and commodity swaps.

   A swap functions similarly to a series of forward contracts, as it involves the exchange of future cash flows, giving it a risk/return profile comparable to a bundle of forward agreements. The main difference lies in the recurring nature of the payments and the flexibility that swaps offer in managing financial risks.

Cap

A cap is a financial agreement in which the seller agrees to make payments to the buyer whenever a specified reference, such as an interest rate or commodity price, exceeds a predetermined threshold known as the exercise value. Conversely, a floor is an agreement where the seller makes payments to the buyer when the reference value falls below the predetermined exercise value. Essentially, a cap functions like a series of call options, while a floor operates like a series of put options, each providing protection against unfavorable price or rate movements based on the agreed-upon limits.

Each derivative instrument has distinct characteristics, offering certain advantages but also presenting potential disadvantages. These drawbacks are not always immediately obvious to the end user, making it critical for market participants to fully understand the risks associated with the derivative contracts they engage in, as well as the suitability of each instrument for their specific needs and objectives.

Why do market participants use derivatives? There are several reasons, including:

1. Speculation: Taking positions in anticipation of market movements.
2. Hedging: Protecting a portfolio of shares, bonds, foreign currency, etc., against unfavorable price changes.
3. Arbitrage: Exploiting price discrepancies between markets or instruments. Position structuring: Creating or modifying specific risk/return profiles.

One common reason for using derivatives, especially in hedging, is portfolio diversification. Classic portfolio allocation theories, such as those by Markowitz and Sharpe, as well as their extensions, offer well-documented strategies for combining risky assets in a portfolio. By diversifying across various assets, investors can spread the risk of loss, reducing overall exposure to market fluctuations.