What are derivatives?

What are derivatives?

A derivative is a financial instrument. It operates like a contract between two parties which states that a specific underlying  The underlying (also known as base value) is the value (e.g. a security, a currency, an index or raw material) on which a derivative (such as an option, a future or a warrant) or a structured product is based. can or must be purchased at a pre-agreed price at a given time. An underlying can be a share  A share is a security which gives investors a stake in a company. Companies raise capital by issuing shares. Shareholders have proprietary rights (e.g. entitlement to dividends) and membership rights (e.g. entitlement to take part in the general meeting and the right to vote). 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.

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 1,000 francs, even if the harvest might only be worth 800 francs 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 People who invest for speculative purposes hope to generate profit through the transaction from future price rises by assuming disproportionately high risks. This is why the risk of loss is also high. Speculation generally tends to be of a short-term nature.. 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 A forward contract is a contract whose performance is defined in advance and fulfilled only at a later date., option contracts  An option contract is a conditional forward contract. In exchange for payment of an option premium, the purchaser gains the right to purchase (call option) or sell (put option) a specific security for a specific price at a later date. However, the purchaser is not obliged to exercise this option. and swaps Swaps are similar in function to forward contracts, but they are specifically linked to cash flow (currencies, interest). In simple terms, swaps can be considered as a series of forward contracts executed one after the other..

• 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 40,000 francs on 3 September – even if the price of gold has dropped to 35,000 francs 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 they actually wish to exercise this right. The option is different for the seller, who is obliged to provide the underlying if requested to do so 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 (e.g. 1 percent) with a variable interest rate (e.g. the 3-month LIBOR).

When are derivatives right for me?

Nowadays, derivatives are mostly far removed from farmers, who wanted to secure the purchase of their harvest at a price agreed on in advance. Derivative financial products have become more complex and varied. The range of products available is difficult for 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.