What are derivatives?

Derivatives are like the theory of relativity. Everyone has heard of them, but only a few people understand exactly what they are. Yet derivatives are a lot less complex than Einstein’s famous theory. The most important information at a glance.

What are derivatives?

A derivative is a financial instrument. It works like a contract between two parties which states that a specific underlying can or must be sold on a certain date at a price agreed in advance. An underlying can be a share or a raw material, for example. A contract can also be concluded for more than one underlying. Derivatives therefore give investors the opportunity to bet on the fact that the price of the underlying will increase or decrease.

For example: Peter is convinced that the price of gold will rise next autumn, while Anna thinks that the price of gold will have fallen by then. Peter therefore purchases the right to acquire 1 kg of gold from Anna for CHF 40,000 on 3 September – even if 1 kg of gold might be worth CHF 50,000 by then. Peter pays Anna a premium in exchange for this right. In September, it is up to him to decide whether to redeem his option or let it expire.

What are derivatives used for?

Derivatives were originally invented so that farmers could protect their harvests in advance. For instance, in January a farmer could oblige a merchant to purchase his harvest of 2 tonnes of potatoes in October for the previously agreed price of CHF 1,000, even if the harvest might only be worth CHF 800 by then. This kind of forward contract has existed since 1750 BC.

The basic principle has not changed much, even if the concept behind it is much more sophisticated nowadays. The obvious advantage remains protection. Investors use derivatives to protect themselves against fluctuations in prices of certain underlyings.

The other possibility is speculation. Investors speculate on future changes in the prices of underlyings, without buying or selling the underlying itself. Derivatives allow them to rely on the fact that a specific underlying will evolve in a certain direction during a set period of time. Investors can use instruments known as leverage products to gain a disproportionately large profit from small price fluctuations, even with low investment amounts.

Are there different types of derivative?

Yes, derivatives can be divided into three categories: forward contracts, option contracts and swaps.

  • Forward contracts: in this case, both parties undertake to fulfil their end of the bargain. If we go back to the earlier example of Anna and Peter, Peter would have to purchase the kilogram of gold for CHF 40,000 on 3 September – even if the price of gold has dropped to CHF 35,000 per kilo by then. Unconditional forward contracts of this kind are called futures if they are carried out on the stock market. If they are not carried out on the stock market, they are referred to as forwards.
  • Option contracts: in this case, the buyer acquires the right to purchase (call option) or sell (put option) underlyings, as illustrated in the first example with Anna and Peter. The buyer can choose whether or not he or she wishes to actually make use of this right. The option is different for the seller, who is obliged to provide the underlying if so requested by the buyer. This makes it a one-sided option, for which the seller receives compensation in the form of a premium.
  • Swaps: whereas forward and option contracts can involve a wide range of underlyings, swaps are based on cash flows. Consequently, swaps represent a type of forward contract on loans, foreign currencies, interest payments and similar cash flows. As suggested by the name, a swap involves exchanging receivables or liabilities. A swap could therefore consist of a regular exchange of a fixed interest rate, such as 1%, with a variable interest rate, such as the 3-month LIBOR.

When are derivatives right for me?

Nowadays, most derivatives are very different from those used by farmers to ensure that their harvest would be purchased at a pre-agreed price. Derivative financial products have since become more complex and varied. The range of products available is difficult for laypeople and beginners to understand. Derivatives bear risks that do not exist with traditional securities. You should therefore invest only if you are extremely familiar with the relevant products and the mechanisms of different derivatives.

Recommended reading: detailed information on the subject can be found in the “The link will open in a new window Special Risks in Securities Trading” brochure published by SwissBanking.

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