5 Popular Derivatives and How They Work

Derivatives are financial contracts whose value is based on the performance of an underlying asset, such as stocks, bonds, or commodities. They can be powerful tools for risk management, speculation, or hedging. Here are 5 types of popular derivatives and a simple explanation of how they work:

1. Futures Contracts

A futures contract is an agreement between two parties to buy or sell an asset at a predetermined price at a specified time in the future. These contracts are commonly used for commodities like oil, gold, or agricultural products.

How it works:

Example: A farmer agrees to sell wheat to a buyer at a fixed price six months from now. Regardless of the market price at that time, both parties must fulfill the contract.

2. Forward Contracts

Similar to futures, forward contracts are agreements to buy or sell an asset at a future date for a price set today. However, unlike futures, forward contracts are customized and traded directly between two parties (not on an exchange).

How it works:

Example: A company needing to buy foreign currency in six months might enter into a forward contract with a bank to lock in the exchange rate today.

3. Options

Options give the buyer the right (but not the obligation) to buy or sell an asset at a specific price, within a set time frame. The two main types of options are call (buy) and put (sell).

How it works:

Example: You buy a call option for stock XYZ at $50 per share. If the stock price rises above $50, you can exercise the option to buy at that price, making a profit. If the price stays below $50, you simply let the option expire, losing only the premium paid.

4. Swaps

A swap is a contract in which two parties exchange cash flows over time. One common type is an interest rate swap, where one party exchanges a fixed interest rate for a floating rate.

How it works:

Example: A company with a loan that has a variable interest rate may enter into a swap agreement to pay a fixed interest rate in exchange for receiving a floating rate. This helps manage the risk of interest rate changes.

5. Credit Default Swaps (CDS)

A credit default swap is a type of insurance against the default of a debt instrument. If the issuer of the debt defaults, the seller of the CDS compensates the buyer.

How it works:

Example: If an investor holds bonds from a company and worries about default, they might buy a CDS from another party. If the company defaults, the CDS seller compensates the investor.

Read also: Derivatives vs Options: What Are the Key Differences?

Why Use Derivatives?

• Hedging:

  Protect against price fluctuations in assets.

• Speculation:

  Make bets on the future price of assets to earn a profit.

• Leverage:

  Control larger amounts of assets with a smaller investment.

DISCLAIMER: Trading commodity futures and options products presents a high degree of risk and may not be suitable for all investors. Losses in excess of your initial investment may occur. Past performance is not necessarily indicative of future results.