What derivatives are and why they exist

A German machine maker sells a machine to a US customer for USD 10 million, to be paid in six months. If the euro strengthens before then, those dollars buy fewer euros and the profit can vanish. One call to its bank today can fix the exchange rate. That call creates a derivative.

A derivativeA contract between two parties whose value depends on the price or level of something else. is a contract between two parties whose value depends on the price of something else. That something else is the underlyingThe asset, rate, index or event whose value a derivative depends on.. It can be a share, a bond, a stock index, an interest rate, an exchange rate, a commodity such as oil or wheat, or even an event, such as a company failing to pay its debts.

The idea is old and simple. A wheat farmer worries the price will fall before harvest. A miller who buys wheat worries it will rise. In spring they agree a price for wheat to be delivered in autumn. Each has removed a worry, and the contract between them is a derivative: its value moves with the wheat price, but no wheat changes hands until autumn.

Four families

Almost every derivative is built from four basic types. Click each one to see what it does. You will meet each of them properly later in this module.

Three reasons to use them

HedgingTaking a position that gains when an existing risk loses, so the two offset. is the reason derivatives exist, but the market needs the others too. SpeculatorsTaking a position to profit from a price move you expect. take the other side of hedgers' trades, and arbitrageursMaking a riskless profit from two prices that are out of line, by buying the cheap and selling the dear. keep the prices of derivatives in line with the prices of their underlyings.

Leverage: why they are powerful and dangerous

Because little cash is paid upfront, a derivative gives a large exposure for a small outlay. This is leverageGaining exposure to a large amount of an asset with a much smaller amount of your own money.. Put down 10,000 to control a position worth 100,000, and a 5% move in the underlying gains or loses 50% of your money. That suits a hedger, who protects a large exposure cheaply. It can ruin a speculator who is wrong.

Where they trade. Some derivatives are standard contracts traded on exchanges, such as futures and listed options. Many more are agreed directly between two parties, over the counterOver the counter: traded directly between two parties, not on an exchange. (OTC), and tailored to their needs (L1.1.04). Measured by notional, the OTC market is many times larger than the exchange-traded one, and its notional runs into hundreds of trillions of US dollars. Notional overstates the money at risk: in a swap on USD 100m, only the interest differences are ever paid. But each side still depends on the other paying, which is counterparty risk, a theme that runs through this whole module.

Here is the exporter from the opening. It can sell its USD 10m forward at 1.10 dollars per euro. Leave it unhedged, hedge half, or hedge it all, then move the exchange rate in six months.

The exporter is owed USD 10m in six months. Its bank offers to buy those dollars then at a forward rate of 1.10 dollars per euro (EUR/USD is quoted as dollars per euro). Try each step before revealing it.

After the 2008 crisis, the G20 countries agreed that standard OTC derivatives should be centrally cleared and reported, and that the rest should carry margin. L1.7.11 explains these reforms. Later levels cover the capital banks hold against derivatives counterparties and the hedge accounting rules (IFRS 9) that let a company show a hedge alongside the risk it hedges.

• A derivative is a contract whose value depends on an underlying: a price, rate, index or event.
• The four families are forwards and futures, swaps, options, and credit derivatives.
• Hedgers use derivatives to remove a risk they already have; speculators to take on risk; arbitrageurs to profit from mispricing.
• A hedge removes losses and gains alike: it buys certainty.
• Small upfront payments give leverage, which magnifies gains and losses.
• Derivatives are zero-sum between the two sides, so each side depends on the other paying: counterparty risk.

Derivative

A contract between two parties whose value depends on the price or level of something else.

Underlying

The asset, rate, index or event whose value a derivative depends on.

Notional

The amount a derivative's payments are worked out on. It sets the size of the contract but is often never paid over.

Counterparty

The other party to a contract: the one who must pay you if the contract moves in your favour.

Hedging

Taking a position that gains when an existing risk loses, so the two offset.

Speculation

Taking a position to profit from a price move you expect.

Arbitrage

Making a riskless profit from two prices that are out of line, by buying the cheap and selling the dear.

Over the counter (OTC)

Over the counter: traded directly between two parties, not on an exchange.

Leverage

Gaining exposure to a large amount of an asset with a much smaller amount of your own money.

Zero-sum

One side's gain is exactly the other side's loss, before costs.