Finance Talk: What are Derivatives?
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by Tom C
Derivatives are one of the more common kinds of securities. In its simplest terms, a derivative is a
type of security the price of which depends upon or is derived from one or more underlying assets.
This could be a bond, stock, commodity, currency or interest rate among others. That definition,
though, incorporates a wide range of different structures. Each one will be treated in a different way
and involve its own set of risks. Here are the most common:
Futures are one of the most common forms of derivatives. They represent a contract among two
parties to buy and sell an asset at an agreed upon price. It’s a good idea if you’re looking to hedge
against a future drop in price of your asset.
Say, for example, you have shares in a major company which are currently worth $70. You’re
worried that the price may drop in which case you make an agreement with another party to sell
your asset at a pre-determined point in the future for a certain price. Let’s say you’re looking to hold
value and sell at $70.
You are in fact entering a bet with the other party. If the value of the shares falls, you’ll be able to
shift them for more than they’re worth. However, if they rise, then the other party will have got
them for a bargain.
Options are similar to futures in that they involve an agreement to buy or sell an asset at an agreed
upon price. The difference here is that you are only exercising an option to buy or sell. There is no
obligation. Again, this is something you can do to hedge against risk.
These derivatives involve an agreement to swap loan terms. For example, if you’re on a variable rate
loan you might want to switch with someone else who has a fixed rate loan. You are buying into the
certainty of the fixed rate, while they are hoping to benefit from a lower rate. Although the loans
remain in each of your names, you will be making payments on one another’s loans. There is a risk in
that if one party defaults or goes bankrupt the other will be forced back into the original loan.
If you’re holding a loan, you may decide to sell it on to a speculator for less than its face value. The
benefit for you is that it releases the majority of capital from your loan and enables you to use that
money to issue a new and more profitable loan. The speculator will hope to make a profit over time
by recouping the full amount of the loan.
Derivatives, then are a wide tent, but with all of these the most important thing is to understand the
risks. Enter into them with your eyes open and they can be worthwhile.
Enrolling in a professional qualification such as the CFA will get you up to speed on this topic and
turn you into an expert in no time!