In finance, there are four basic types of derivatives: forward contracts, futures, swaps, and options. In this article, we’ll cover the basics of what each of these is.
What Are Derivatives?
A derivative is a financial instrument that derives its value from something else. The value of a derivative is linked to the value of the underlying asset. In simpler terms, think of putting down a bet on a hand of blackjack as the underlying and then someone else making a bet on the success of your blackjack hand as a derivative of the underlying.
Types of Derivatives
There are generally considered to be 4 types of derivatives: forward, futures, swaps, and options.
An options contract gives the buyer the right, but not the obligation, to buy or sell something at a specific price on or before a specific date. With a forward contract, the buyer and seller are obligated to make the transaction on the specified date, whereas with options, the buyer has the choice to execute their option and buy the asset at the specified price. Learn more about options in the Fundamentals of Options article.
A forward contract is where a buyer agrees to purchase the underlying asset from the seller at a specific price on a specific date. Forward contracts are more customizable than futures contracts and can be tailored to a specific commodity, amount, and date.
A futures contract is a standardized forward contract where buyers and sellers are brought together at an exchange. The buyer is obligated to purchase the underlying asset at the set price and date.
A swap is an agreement to exchange future cash flows. Typically, one cash flow is variable while the other is fixed. Say for example a bank holds a mortgage on a house with a variable rate but no longer wants to be exposed to interest rate fluctuations, they could swap that mortgage with someone else’s fixed-rate mortgage so they lock in a certain rate.
CDS, or credit default swap, is a financial derivative that "swaps" (or trades) risk of default on debt. It is insurance on default of a credit instrument, like a bond. If you're a buyer of a CDS contract, you are "betting" that a credit instrument will default. If it does default, the buyer would be made whole.
In exchange for that protection, the CDS buyer makes fixed payments to the CDS seller until maturity. Additionally, the buyer may pay or receive additional "points upfront" to level out the risk associated the trade (i.e. if the fixed payment that was set at a contract's inception is not high enough to compensate for the risk, the buyer might have to "pay extra upfront" to enter the contract").
Why Use Derivatives?
There are two broad categories for using derivatives: hedging and speculating.
Derivatives can be used as a way to limit risk and exposure for an investor. For example, let’s say an airline company is worried that the price of oil will rise in the next year causing their fuel costs to rise and cut their profitability. In this case, the airline could use a derivative contract (likely a forward contract) to purchase oil at a preset price in the future, thereby limiting their exposure.
On the flip side, instead of using derivatives to reduce risk, speculators could use derivatives to generate profits from it. For example, if I believe that the price of a stock will rise over the next 6 months, I could purchase a call option at today’s price and potentially make a sizable profit if the stock does rise dramatically.