A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset (like a security) or set of assets (like an index). Common underlying instruments include bonds, commodities, currencies, interest rates, market indexes and stocks.
Futures contracts, forward contracts, options, swaps, and warrants are common derivatives. A futures contract, for example, is a derivative because its value is affected by the performance of the underlying contract.
Similarly, a stock option is a derivative because its value is “derived” from that of the underlying stock. While a derivative’s value is based on an asset, ownership of a derivative doesn’t mean ownership of the asset.
Generally belonging to the realm of advanced or technical investing, derivatives are used for speculating and hedging purposes. Speculators seek to profit from changing prices in the underlying asset, index or security.
For example, a trader may attempt to profit from an anticipated drop in an index’s price by selling (or going “short”) the related futures contract. Derivatives used as a hedge allow the risks associated with the underlying asset’s price to be transferred between the parties involved in the contract.
Derivatives Between Two Parties
For example, commodity derivatives are used by farmers and millers to provide a degree of “insurance.” The farmer enters the contract to lock in an acceptable price for the commodity, and the miller enters the contract to lock in a guaranteed supply of the commodity. Although both the farmer and the miller have reduced risk by hedging, both remain exposed to the risks that prices will change.
For example, while the farmer is assured of a specified price for the commodity, prices could rise (due to, for instance, a shortage because of weather-related events) and the farmer will end up losing any additional income that could have been earned. Likewise, prices for the commodity could drop, and the miller will have to pay more for the commodity than he otherwise would have.
For example, let’s assume that in April 2017 the farmer enters a futures contract with a miller to sell 5,000 bushels of wheat at $4.404 per bushel in July. At expiry date in July 2017, the market price of wheat falls to $4.350, but the miller has to buy at the contract price of $4.404, which is much higher than the market price of $4.350. Instead of paying $21,750 (4.350 x 5000), he’ll pay $22,020 (4.404 x 5000), and the lucky farmer recoups a higher-than-market price.
Some derivatives are traded on national securities exchanges and are regulated by the SEBI Other derivatives are traded over-the-counter (OTC); these derivatives represent individually negotiated agreements between parties.
How Derivatives Benefit Buyers and Sellers
Let’s use the story of a fictional farm to explore the mechanics of several varieties of derivatives.
Gail, the owner of Healthy Hen Farms, is worried about the volatility of the chicken market, with all the sporadic reports of bird flu coming out of the east. Gail wants to protect her business against another spell of bad news. So she meets with an investor who enters into a futures contract with her.
The investor agrees to pay $30 per bird when the birds are ready for slaughter in six months’ time, regardless of the market price. If, at that time, the price is above $30, the investor will get the benefit as they will be able to buy the birds for less than market cost and sell them on the market at a higher price for a gain. If the price falls below $30, Gail will get the benefit because she will be able to sell her birds for more than the current market price, or more than what she would get for the birds in the open market.
By entering into a futures contract, Gail is protected from price changes in the market, as she has locked in a price of $30 per bird. She may lose out if the price flies up to $50 per bird on a mad cow scare, but she will be protected if the price falls to $10 on news of a bird flu outbreak. By hedging with a futures contract, Gail is able to focus on her business and limit her worry about price fluctuations.
Today, derivative contracts exist on a variety of commodities such as corn, pepper, cotton, wheat, silver, etc. besides commodities. Derivatives contracts also exist on a lot of financial underlying assets like stocks, interest rates, exchange rates, etc. Derivative products initially emerged as hedging devices against fluctuations in commodity prices. Financial derivatives came into the spotlight in the post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become popular and by
1990s, they accounted for about two – thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously in terms of instruments available, their complexity and also turnover. In the class of equity derivatives the world over, futures and options on stock indices have gained more popularity than individual stocks and especially institutional investors, who are major users of index linked derivatives. Even small investors find it more useful due to high correlation of the popular indexes with various portfolios and ease of use. The lower costs associated with index derivatives vis-à-vis derivative products based on individual securities is another reason for the growing use.
The source of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop from the time of sowing to the time of crop harvest.
Through the use of simple derivative products, it was possible for the farmer to partially or fully transfer price risks by locking-in asset prices. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk.