Derivatives: The $800 Trillion Market You Don’t Understand

If you’ve dipped your toes into the world of investing, you may have heard of “derivatives”. No need to worry if you don’t know calculus. Financial derivatives are a lot easier, and a lot more fun!

In mathematics, aa derivative is directly related to the function that it tracks, ergo it derives its value from some other function. Similarly, a financial derivative is a security that changes in value depending upon the change in value of some other financial security or instrument. When buying a derivative, the investor does not own the underlying asset. He/She instead bets on the asset’s price movement with another party. As with any security, the riskier the asset, the higher the potential for profit and loss.

Investors buy and sell derivatives to secure a bullish or bearish position, or to hedge a position, meaning to offset the potential risk of a separate investment. The two types of derivatives are over-the-counter (OTC) which are traded through private contracts made between two parties, as well as exchange, which as you might’ve guessed, are traded on an exchange. The topics we’ll be going over here are options, futures, forwards, swaps, as well as how to use them to create synthetic positions.

Options Contracts

An option gives the holder the right, but not the obligation, to buy or sell a certain number of shares of a company from another investor within a fixed period of time. The purchase price, also called the strike or exercise price, is fixed and cannot be altered at a later date, which is what makes options valuable. An option to buy at the earlier price is a call and an option to sell at the earlier price is known as a put. Know these terms before moving on, as they are very common in the world of derivatives.

Here’s an example to illustrate options in use: Sally has a plot of land she wishes to sell for $1 million. Bob wishes to buy the land to build condos, but he has not yet secured funding. In the meantime, he pays Sally $20,000 for the option to buy the plot within the next month at the $1 million price point. Sally now follows the terms of the arrangement by taking the land off the market for that time. If Bob is not able to secure funding, the option expires and is worth null. Bob loses his $20,000. Conversely, if Bob does secure funding, he can buy the land from Sally for the agreed-upon $1 million. Even if foreign investors make Sally an offer for ten times that amount, she is legally obligated to sell the plot to Bob as stipulated in their options contract.

Options are most commonly bought and sold by investors for the purpose of hedging risks in the stock market equities, as they allow shares to be sold at the exercise price even if they go into a loss or the market crashes.

Futures and Forward Contracts

Futures Contracts are similar to options, though they are often based upon commodities like wheat or oil. In a futures contract, an individual agrees to deliver, or on the receiving end to accept delivery of a certain amount of a commodity or asset at fixed periodic times, at a stipulated price. This is done in order to transfer risk and return between parties. No payment is made at the time that a futures contract is negotiated. It is only when a delivery is to be made that money changes hands. This is called the settlement date.

For example, if the company ApplesGalore sells apples at $2 to Applebees, which in turn sells apple pie at $5, they can negotiate a futures contract with an investor. This would mean that neither company has to worry about fluctuations in the price of apples. If there are suddenly an abundance of apples and the price drops to $1, ApplesGalore doesn’t have to worry about losing out on profits as the investor pays the difference. Conversely, if a disease kills much of the apple tree population and the price of an apple skyrockets to $5, then the investor pockets the difference of $3. ApplesGalore and Applebees are transferring the risk of damaging price fluctuations to a third party, but they also then miss out on any extra potential profits.

Futures contracts change in value alongside the change in value of the underlying asset, and are considered to be highly liquid. For example, if the price of apples in the previous example were to jump to $5 and Applebees no longer required them as they stopped selling apple pie, they could sell the contract for immediate profit to another company that would pay to buy apples below market price.

Forward contracts are very similar to futures contracts, however, unlike futures, they are not traded on an exchange. Instead, they are closed-door, private agreements between parties. Forward contract settlements are also made at the date at which the contract expires rather than futures, whose value is determined on a daily basis.

Swaps

A swap agreement is a derivative that allows entities to exchange financial instrument cash flows and/or liabilities within a specified period and under certain terms. Although the swap can involve virtually any underlying asset, the most common is an interest rate swap. Here’s how it goes:

Applewasps is a new entrant in the restaurant game and therefore has a low credit rating. On this low rating, they are able to get a loan of $1 million at a variable interest rate of 7%. Meanwhile, Applebees has been operating for decades and also has a $1 million loan, but at a fixed rate of 5%. What these two parties can do is write up a swap agreement contract with a swap bank, which would arrange the transfer or swap of both cash flows. In this arrangement, all parties may benefit. The swap bank typically acts as an intermediary wherein both counterparties remain anonymous, and the entire deal is brokered by said bank. Applewasps is able to receive a much lower and fixed interest rate, allowing them to grow the business without interest rate risk and build a strong credit history. As well, variable interest rates are lower for those with strong credit ratings, meaning Applebees could reduce their interest rate from their fixed 5% to a variable 4%.

Synthetic Positions

If you read our article on the equity market a couple of weeks ago, you may recognize the term “synthetic” as relating to synthetically-backed ETFs. The formal definition of a synthetic position is ownership of a security whose purpose is to artificially replicate the performance of another financial security or instrument.

Synthetic position are usually created for one of two reasons. The first is that they require less capital than buying the underlying asset. The second is that you are able to use them to have an indirect short position, which still requires less capital, but also makes short position much more freely accessible to retail investors under strict regulation. The downside is that synthetic short positions have an expiry date as well as unlimited downside. Here’s an example for you to get a better idea:

Harrison believes that Elon Musk is a fool and Tesla will crash and burn in the next fiscal year. Based on this, Harrison buys 100 put options — options to sell at an earlier price — for $3 per put, when Tesla’s share price is $235. This costs Harrison a total of $300, but he is confident in his synthetic short position. Eleven months and twenty twenty-nine days pass. Harrison was wrong, and the share price of Tesla now sits at $335, ergo his put options are worth null and Harrison is very upset. This is why these positions are considered to have “unlimited downside”. In a different scenario, let’s say that Harrison turned out to be correct, and Tesla’s share price tumbled down to a measly $135. He could sell his 100 put options for a profit, as investors with long position trying to exit would be wanting to cut their losses as much as possible.

Risks

Private derivative contracts arranged outside of any exchange are highly susceptible to counterparty risk. This is the risk that the other party in the agreement will fail to pay the amount due at the stipulated time. This risk can be reduced with a co-signer or trustworthy third-party guarantor.

Call options are considered as having a lower risk than stocks as you can exit your position at any point for a set price. Keep in mind, however, that they also have unlimited downside and an expiry date, which can be catastrophic if large sums are invested at the wrong time.

Forward contracts come with the implicit default risk that the appropriate party cannot pay the amount due at the end of the contract. Futures contracts do not come with this same risk, as they are traded on an exchange with clearinghouses that mandate participants to have minimum account balances and make sufficient payment on-time. Clearinghouses do take on a substantial risk that, despite their best efforts, the buyer won’t pay. They also allow investors to buy and sell securities without the need to make direct contact with who they are buying from or selling to.

It’s common for swap agreements to have a winner and a loser by the end, especially when it comes to interest rate swaps. Variable interest rates, along with other common swap instruments, usually change enough over the course of an agreement that one of the two counterparties would have been better off if they hadn’t signed the contract. This is the risk that’s taken when entered into such an agreement.

Are Derivatives Evil?

It’s time to address the elephant in the room. You may have heard from somewhere or someone that derivatives are the root of all evil in the world, and you should never buy, let alone think of buying them. You may have heard the quote from Warren Buffett: “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal” What you may not have heard is that derivatives are an $800 trillion (CAD) worldwide market, and that Buffett quote is from all the way back in the year 2002. More recently, he said “I don’t think they’re evil per se. There’s nothing wrong with having a futures contract or something of the sort.” He clarified further, stating derivatives can add meaning value to both retail and institutional investors, as long as they follow due diligence and buy in moderation. The “real problem,” he says, comes from overexposure from banks and “uninformed investors”. Derivatives like options, futures, forwards, and swaps represent huge potential value for investors. It’s a good idea to tap into that potential, rather than squandering it based on shaky logic and misleading claims.

Hopefully this article helped you gain a deeper understanding of the derivatives market and its role in synthetic positions. If it did, be sure to review key takeaways and take a look at some next steps to support us and further your own learning.

Key Takeaways

1. A financial derivative is a security that changes in value depending upon the change in value of some other financial security or instrument.
2. Derivatives can be traded over-the-counter through private contracts, or on an exchange.
3. Options allow investors to buy or sell equity in a company at a previous price — strike or exercise price — stipulated when the option is created
4. An option to buy is a call and option to sell is a put.
5. Options are commonly bought to hedge risk.
6. Futures are like options but are often based upon commodities, and involve an agreement obligating one party to deliver an asset at fixed times, and the other party to pay a stipulated price.
7. Forward contracts are essentially futures contracts but are instead closed-door private agreements made between parties.
8. Swap agreements allow for the exchange of financial instrument cash flows and/or liabilities within a specified period and under certain terms, the most common of which is an interest-rate swap.
9. Synthetic positions are a way to replicate the performance of underlying financial securities or instruments using derivatives, commonly used to create synthetic short positions and ETFs.
10. Derivative contracts can be subject to a variety of risks, including counterparty risk, default risk, and interest-rate risk.
11. Derivatives are not inherently evil.

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