What are Financial Derivatives and Examples (In Simple Words)

Financial derivatives are instruments whose value depends on an underlying asset, such as stocks, bonds, currencies or raw materials. In practice, they are contracts whose price is linked to the performance of another asset.

Today, for those who operate on the stock exchange, derivatives play a crucial role. According to recent data, the global derivatives market has reached a notional value of over 600 trillion dollars, highlighting their diffusion and importance. These instruments are used by financial institutions, companies and investors to manage risks related to changes in interest rates, currencies and raw material prices. For example, a European company that exports to the United States could use a derivative contract to protect itself from fluctuations in the euro-dollar exchange rate, thus ensuring stability in revenues.

However, despite the benefits in risk management, derivatives have been at the center of debates, especially after the 2008 financial crisis, where the excessive and complex use of some derivative instruments contributed to market instability. After all, these instruments are used both to cover financial risks and for speculative purposes. Let’s find out in depth what derivatives are, how they work and what the potential risks associated with them are.

What are derivative instruments: meaning and definition

Financial derivatives are contracts whose value derives from the performance of an underlying asset or the occurrence of an observable future event. The underlying asset can be financial, such as stocks, interest rates, currencies, or stock indices, such as commodities. The term "derivative" emphasizes this dependence on the value of another asset.

The main function of derivatives is to transfer the risk associated with the underlying asset between the parties to the contract. For example, a farmer might use a futures contract to sell his crop at a price set in advance, thus protecting himself from possible price decreases when the actual sale is made. Similarly, an investor could buy an option to have the right, but not the obligation, to buy shares at a certain price by a certain date, benefiting from any price increases without being forced to buy in the event of a decline.

Precisely because of the multiplicity of possible options, derivatives can be grouped into two categories:

• Commodity derivatives: derivatives linked to real assets such as oil, gold, wheat, coffee and which have the purpose of covering the risks of fluctuations in the cost of raw materials;
• Financial derivatives: linked to shares, securities, currencies, interest rates that combine the purpose of coverage (hedging) with the actual investment, exploiting what in finance is called the leverage effect. What derivatives are is starting to become clearer.

How do financial derivatives work and what are they used for?

Financial derivatives, therefore, function as contracts between two or more parties, in which the value of the contract is linked to the performance of an underlying asset. But these instruments can be used for different purposes: here are some.

• Risk coverage (Hedging): companies and investors use derivatives to protect themselves from price fluctuations that could negatively affect their activities or investments. For example, a company that imports raw materials from abroad could use a forward contract to fix the exchange rate, thus avoiding the uncertainty associated with currency variations.
• Speculation: investors can use derivatives to bet on future price variations of the underlying asset, trying to obtain profits. For example, a trader might buy a call option on a stock, hoping that the stock price will rise above the strike price of the option, allowing them to buy the stock at a price below market value and make a profit.
• Arbitrage: Arbitrage is the practice of taking advantage of price differences for the same asset in different markets. Derivatives can be used to exploit these discrepancies by buying the asset in a market where it is undervalued and selling it in another where it is overvalued, resulting in a risk-free profit.
• Portfolio Management: Institutional investors use derivatives to manage their portfolio exposure to certain risks or to replicate the performance of an index without having to buy all of the index’s components.

Most Common Types of Financial Derivatives

Financial derivatives come in many different forms, each with specific characteristics that make them suitable for particular hedging or speculation needs.

Forward and Futures Contracts

• Forward Contracts: These are customized agreements between two parties to buy or sell an underlying asset at a specific price on a future date. Because they are traded over-the-counter (OTC), forwards offer flexibility in terms of quantity, maturity, and other contractual terms. However, they carry greater counterparty risk, as they are not standardized or regulated by an exchange.
• Futures Contracts: Similar to forwards, futures are standardized contracts traded on regulated markets. This standardization affects aspects such as contract size, expiration dates, and delivery methods. The presence of a clearing house reduces counterparty risk, ensuring the fulfillment of contractual obligations. Futures are commonly used to hedge risks related to commodities, currencies and interest rates.

Options

options are contracts that give the holder the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a predetermined price (exercise price or strike price) by a specific expiration date. The buyer of the option pays a premium to the seller to acquire this right.

• Call options: give the holder the right to buy the underlying asset at the exercise price. Investors buy call options when they expect the price of the underlying asset to increase.
• Put Options: Give the holder the right to sell the underlying asset at the strike price. Investors buy put options when they expect the price of the underlying asset to decrease.

Options are versatile instruments used for both hedging and speculation, offering the ability to limit potential losses while maintaining opportunities for profit.

Swaps

swaps are contracts through which two parties exchange cash flows or other financial variables according to predefined terms. Common swaps include:

• Interest Rate Swap: Two parties exchange interest payments on an agreed-upon notional amount, usually one at a fixed rate and the other at a floating rate. This type of swap is used to manage interest rate exposure;
• Currency Swap: involves the exchange of principal and interest in different currencies. Multinational companies use currency swaps to manage exposure to exchange rate risk arising from transactions in different currencies;
• Credit Default Swap (CDS): works as a sort of insurance against the default of a debtor. The buyer of the CDS pays a periodic premium to the seller, who undertakes to compensate the buyer in the event of default or other credit event of the reference entity.

Other derivatives

In addition to the main categories, there are other derivative instruments used for specific needs. Here are some.

• Contracts for Difference (CFD): These are agreements between two parties to exchange the difference between the current value of an underlying asset and its value at the time the contract is signed. CFDs allow investors to profit from price changes without actually owning the underlying asset. They are popular instruments in speculative trading, especially for accessing stock, currency and commodity markets.
• Securitized instruments: securitization involves the transformation of a set of illiquid assets (such as loans or mortgages) into tradable securities. These derivative securities allow investors to access cash flows generated by diversified underlying assets, offering investment and risk management opportunities.

The derivatives market and possible risks

First of all, it is worth noting that derivatives are traded both on the Stock Exchange and on over-the-counter or OTC markets (outside the Stock Exchange) created by professionals and financial institutions and which are not required to comply with the regulations and limits of the main price lists.

But what are the risks of financial derivatives? Despite the advantages, the following must still be considered:

• the market risk: the value of derivatives depends on the performance of the underlying asset and may undergo unexpected changes;
• the counterparty risk: in OTC contracts, there is the possibility that one of the parties does not honor its commitment;
• the leverage effect: derivatives can amplify both gains and losses, making them high-risk instruments;
• a certain complexity: some derivatives, such as CDS, can be difficult to understand, increasing the risk of improper use.

Derivatives in recent history: some examples to understand

Now that we have understood what derivatives are and what they are used for, let’s proceed with a practical example that involved one of the oldest banks in the world: Monte dei Paschi di Siena.

The MPS scandal involved a contract that did not appear in the balance sheet, aimed at charging Nomura for losses caused by a derivative on mortgages. In other words, to beautify its balance sheet, Monte dei Paschi unloaded on Nomura the losses resulting from a highly risky derivative (Alexandria).

And the 2008 crisis? That too was caused by a particular category of derivatives, the aforementioned credit default swaps, used by investors to protect themselves from the bankruptcy, with related default, of their debtor (the most famous example is that of the CDS on Greek debt).

The crisis was due to the sudden distrust of operators for the underlying instrument (real estate), from which these credit default swaps derived. Distrust justified among other things by the unsecured loans that the various banks granted by basking in the value of the real estate.

From here began a vicious circle that extended the crisis to the entire derivatives sector, to banks and to the entire world.

Original article published on Money.it Italy. Original title: Cosa sono i derivati finanziari ed esempi (in parole semplici)