Corporate Derivatives

Derivatives are financial contracts whose value is determined by an underlying asset or group of assets. It is often used for stocks, bonds, currencies, interest rates, market indexes and commodities such as oil, gasoline or gold.

Derivatives are typically traded over-the-counter (OTC), but also as exchanges. For OTC trades, it occurs between two traders and is traded through a financial intermediary. Exchanges have set standardized contract terms and are more heavily regulated. CME Group, the Korea Exchange and Eurex are some of the largest derivative exchanges.

Types of Derivatives

1. Forwards and Futures — These two types are similar. The contracts’ buyers are obligated to buy the asset at a pre-agreed price on a specified future date. Forwards are OTC and more flexible than futures because the contract parties can choose the underlying asset, how much of the asset to trade and when the transaction will occur. Futures are traded on exchanges and have more standardized contracts.
2. Options — These are similar to futures with the exception of the obligation. The contract’s buyer has the right to act but is not obligated to buy or sell the underlying asset at a predetermined price. They are able to exercise the option on a date of their choosing or on the maturation date.
3. Swaps — These are contracts that allow cash flow to be exchanged between the buyer and seller. Typically, a fixed cash flow is exchanged for a floating cash flow. Some common types of swaps are interest rate swaps and currency swaps.

Advantages

Some advantages of derivatives are they hedge risk exposure, help determine the price of underlying assets, increase market efficiency and provide companies access to assets and markets that may have been unavailable to them originally. Additionally, derivatives are also cheaper because they can be purchased on margin.

Disadvantages

Some disadvantages of derivatives are there is high risk because unpredictable behavior and speculation can result in huge losses. In addition, there is the possibility of counterparty risk, especially for OTC derivatives, because one of the parties may default since the trading between the two parties is unregulated. Furthermore, it is challenging to value derivatives perfectly because they are based on the value of another asset and also sensitive to changes in supply and demand factors such as changes in interest rates and the expiration date.