Derivative securities (often called “derivative instruments” or just “derivatives”) are important components within the financial system. They are defined as financial instruments whose value derives from other basic underlying variables. These variables can be assets like stocks, bonds and commodities, but can also refer to conditions and events such as the amount of rainfall in Kansas in August. At their core, derivatives are tools to assume or shed risk.
There are many types of financial derivatives, but they can be classified into five major families: linear, non-linear, swaps, structured products and hybrid products. While each family possesses unique characteristics, all derivatives share certain common features.
Common Features of Derivatives
Derivative securities share these characteristics:
- Uses. All derivatives are utilized in one of three ways. They can be used to reduce (hedge) the risk created by a specific financial exposure. For example, cattle ranchers might trade futures contracts that gain value if the value of their herds declines. Alternatively, you can use derivatives to bet on the direction of the underlying variable’s value (speculation). Finally, you can use derivatives to offset positions in several instruments, thereby locking in profit without assuming additional risk (arbitrage).
- Trading. Derivatives can be traded on organized markets or as private treaties between two or more counterparties in the over-the-counter (OTC) market. In an organized market, such as a stock exchange or futures exchange, derivatives have an observable price. That’s not true for OTC derivatives, although computer models can be used to calculate a value.
- Leverage. Generally, derivatives allow traders to gain market exposure with little or no initial investment, a characteristic known as leverage. For example, you can use an option to control 100 shares of stock for just a fraction of the stock’s cost.
- Measures of value. There are four ways to describe the value of a derivative. These include the market price, which is the amount a trader will pay or receive to trade the derivative. The value is an estimate of how much you would be willing to pay or receive to trade the derivative. The premium is the upfront cost you pay or receive to trade the derivative. The profit & loss (P&L) is the total value you gain or lose in a trading strategy that involves derivatives. P&L includes the initial premium as well as either the current unrealized (i.e., on paper) value or the realized (i.e., actual) payoff.
- Outcomes. Derivatives eventually expire. They can do so according to a fixed schedule, or they might expire in response to some event. After a derivative expires, it is worthless. Traders might need to make a final settlement of their derivative positions at expiration. Settlement involves the exchange of cash or other assets between counterparties. Derivative positions can usually be unwound (i.e., liquidated via sale or offset) before expiration. Some derivatives can be terminated before expiration if certain conditions are met. Some derivatives can be executed, meaning that a counterparty (or a third-party entity such as a clearing house) can force settlement before expiration. For example, you can execute a call option on a stock, thereby purchasing the shares at the price specified by the option contract.
The Role of Clearing Houses
Clearing houses oversee the trading of certain derivatives (options, futures and exchange-traded swaps) on exchanges. They are third-party intermediaries that act as buyers to every seller and sellers to every buyer. For example, the Options Clearing Corporation regulates and guarantees option trading on exchanges. The primary function of clearing houses is to ensure that counterparties fulfill the contractual obligations specified for a derivative instrument. They are responsible for several activities including:
- Clearing trades. Trades are cleared before they are settled. Clearing reconciles orders between buyers and sellers, ensuring all information is correct and all accounts verified.
- Settlement. The transfers of cash or other assets between the accounts of counterparties.
- Margin management. Some derivative positions require a cash down-payment, known as initial margin, as well as a continual cash deposit known as maintenance margin. Clearing houses collect and maintain margin monies.
- Delivery. Clearing houses regulate and guarantee the delivery of cash and underlying assets.
- Reporting. Clearing houses report trading data such as volume and open contracts.
Futures and options traders must either be members of the clearing house or be represented by members (i.e., brokers).
The value of linear derivatives varies linearly with the value of the underlying asset. That is, a price move by the underlying asset will be matched with an almost identical move by the derivative. In technical terms, these trades have a delta of 1.0. Delta is the sensitivity of derivative’s price change to that of its underlying.
Linear derivatives are traded OTC or on exchanges that are regulated by clearing houses, and provide leverage by requiring only limited investment. Types of linear derivatives include:
- A contract for difference (CFD). The counterparty of a CFD is required to pay the other counterparty the difference between the current price (spot price) of the underlying versus the price specified in the contract (contract price). On days when the spot price is below the contract price, the CFD buyer pays the difference to the seller. On days when the spot price closes above the contract price, the seller pays the difference to the buyer. This is known as the daily margin call. The underlying asset can be a commodity, a foreign exchange rate, an index value, a bond or an equity (stock).
Futures contracts. These are highly standardized contracts that trade on futures exchanges. They specify a predetermined price and a specific future date at which an underlying asset will be exchanged. Buyers and sellers interact through their brokers and the futures clearing house, thereby mitigating the risk that a counterparty that fails to perform will impact the other counterparty. Both buyer and seller submit initial and maintenance margin. There is no premium, so the margin requirements determine the degree of leverage. During the daily margin call, the contract price is marked-to-market, (MtM, meaning updated to the current price). The counterparty that loses money for the day (negative MtM) pays the loss to the other counterparty. In this way, each counterparty accumulates profits and losses. Futures traders can unwind their positions at any time. The typical underlying assets are debt securities, equities, indexes, foreign exchange rates and commodities. Some contracts do not require the exchange of the underlying at settlement
they are cash-settled. 3. Forward exchange contracts. These are OTC versions of future contracts that are neither standardized nor intermediated by a clearing house. There is no margin and no daily margin calls. That means that the counterparty with a positive MtM is subject to default risk from the other counterparty. These contracts are highly customizable and are usually held until expiration, when they are settled by the counterparties. The underlying can be any variable.
Swaps are contracts that require the exchange of cash flows on specified dates (the reset dates). The two exchanged cash flows (known as legs) depend on the type of swap. For example, the counterparties might exchange interest payments from a fixed- and adjustable-rate bond. Swaps have the highest trading volume among derivatives. They can be highly customized and usually trade OTC, although certain standardized ones trade on exchanges. OTC swaps resemble forwards in that the counterparties are subject to default risk.
The sizes of the cash flows are determined by a notional amount of the underlying variables. For example, a swap’s notional amount might be $1 billion in Treasury bonds. For most swaps, neither trader needs to own $1 billion (or any amount) of bonds. The notional amount is simply used to figure the interest payment that would be received had a counterparty owned the $1 billion in Treasury debt. The value of a swap is based on the present value of estimated future cash flows.
The main swap categories include:
- Interest rate swap (IR swap). The idea behind this OTC swap is to exchange a floating-rate exposure for a fixed-rate one. The fixed leg pays cash flows tied to a fixed rate. The floating leg pays cash flows tied to a floating rate index, such as LIBOR. There is no exchange of notional amounts at swap expiration, and no upfront payment is necessary. Both legs are denominated in the same currency. On the reset date, the cash flows are usually netted against each other so that only the difference is sent from the negative leg to the positive one. The swap is subject to counterparty default risk.
- Cross-currency swap. This is like an IR swap, except each leg is in a different currency. In these swaps, the notional amounts of each currency are exchanged at the contract start and expiration dates. Payments are made in the original currency.
- Credit default swap. In this swap, the buyer pays a premium fixed or floating leg to the seller. In return, the seller agrees to make a cash payment to the buyer if an underlying bond has a negative credit event (default or ratings downgrade).
- Total return swap. In this swap, the total return leg pays cash flows based on total return (i.e., price appreciation plus interest payments) of the underlying asset. The premium leg pays cash flows that are based on a floating or fixed interest rate index. The effect is to transfer the risk of the total return asset without having to own or sell it.
Non-linear derivatives are option contracts known as puts and calls. These contracts give buyers the right, but not obligation, to buy (calls) or sell (puts) a set amount of the underlying asset at a specified price (the strike price) before or at expiration. They can be traded OTC, but most are listed on exchanges. The payoffs from option positions are non-linear with respect to the price of the underlying. Option premiums are determined by computer models that use discounted cash flows and statistically-determined future values of the underlying asset.
The different types of options include:
- An American option where value is based on the difference between the underlying’s current price and the contract’s strike price, plus additional value due to the amount of time until expiration and the underlying’s volatility. The buyer can exercise the option at any time until expiration.
- A European option, which is the same as the American option, except the buyer cannot exercise the option until expiration.
- A Bermuda option, which is like a European option, except the buyer can also exercise the option on predetermined dates, usually on one day per month.
- Exotic options. These include Asian, digital and barrier options. Each has a different payoff rule to suit specialized needs.
These are complex financial instruments composed of several basic instruments that are combined for specific risk/reward exposures. They include:
- Asset-backed securities, which are credit-linked products tied to various types of debt including mortgages, car loans, corporate loans and more.
- Capital-guaranteed products, which provide full or partial reimbursement of invested capital. For example, a combination of a zero-coupon bond and an equity option that profits from market upswings.
- Callable products, which are securities that can be terminated before expiration at the behest of the issuer or holder.
- Auto-callable products, which are securities that automatically terminate before expiration based upon specific events.
- Interest rate products, which are complex derivatives that provide protection from adverse interest rate moves.
This is a catch-all category for financial instruments that can exhibit varying behaviors based upon current conditions. The prototypical example is a convertible bond, which can behave like a bond or a stock based on the relationship between the underlying stock price and conversion ratio. You can think of a convertible bond as a hybrid marrying a regular bond with an embedded call option on the issuer’s stock.
Video of the Day
- Futures Fundamentals: The Global Derivatives Marketplace
- Northeastern University: Introduction to Derivatives: How They Work and How to Trade Them
- CME Group: Futures Contracts Compared to Forwards
- Investopedia: Clearing House
- OptionsTrading.org: Types of Options
- Investopedia: Different Types of Swaps
- Investopedia: An Introduction to Structured Products
- Investopedia: An Introduction to Convertible Bonds