INVESTINGin.org » Investing in Derivative Instruments

Investing in Derivative Instruments

Definition of Derivatives

Derivative – a security whose price is derived from one or more underlying assets.

The derivative security is a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.

Most derivatives are characterized by high leverage.

Derivatives are generally used to hedge risk, but can also be used for speculative purposes.

Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Because derivatives are just contracts, just about anything can be used as an underlying asset.

There are three major classes of derivatives:

Futures/Forwards, which are contracts to buy or sell an asset at a specified future date.
Options, which are contracts that give a holder the right to buy or sell an asset at a specified future date.
Swaps, where the two parties agree to exchange cash flows or returns.

There are two major groups of derivative contracts in terms of trading:

Over-the-counter (OTC) derivatives (swaps, forwards).
Exchange-traded derivatives (ETD) (options, futures).

Benefits of Investing in Derivatives

potential for large gains (through leverage)
no need to own the underlying
can limit losses on underlying (when combined with the underlying)

Negatives of Investment in Derivative Instruments

potential for large losses (through leverage)
counter-party risk
zero-sum instrument (someone will always win while the counter-party will lose)
some derivatives are very complex, requiring thorough understanding of the matter
used mainly for hedging and for speculation, hence, of limited investments value to average investor