Understanding derivatives

Where futures and forwards require both parties to make a transaction at a specified price on a given date, options require one side to do this, while the other has a choice in determining whether the trade takes place with the party; paying more for this privilege. 

There are basically two types of option: one where the buyer has the right but not the obligation to transact (or a call option), and the other where the seller has the right (a put option).

For example, airlines often use call options as a way of making their fuel costs more predictable. 

Swaps

Swap contracts are where two counterparties agree to exchange their cash flows: a fixed for a floating rate, as is the case with fixed-rate mortgages; or exchanging two different interest rates, underlying currencies or even bond default rates.

Derivatives can be used to speculate on the direction of an asset’s price.

For example, if a firm wants a fixed-rate loan, it can agree a floating-rate loan from a bank and enter an interest rate swap to get a fixed rate and hedge the interest rate risk – something with obvious advantages in the current rising rate environment, if you manage to get the timing right.

Advantages

Derivatives offer investors multiple advantages. Firstly, they can be used to hedge a financial position, protecting against potential losses if the value of an underlying asset changes markedly.

Similarly, derivatives can be used to speculate on the direction of an asset’s price, or to arbitrage market inefficiencies.

In this way, derivatives can increase market efficiency. By using derivative contracts, you replicate the payoff of the underlying assets.

The prices of those assets and their derivatives will tend towards equilibrium, thus aiding market efficiency.

Derivatives also allow investors to use their capital with greater efficiency.

For example, commodity futures’ spot prices (the price right now) can serve as an approximation of their underlying price.

Derivatives also allow investors to use their capital with greater efficiency, by enabling them to gain exposure to a range of assets without equivalent cash.

In this sense, it is a form of leverage, with the risk that the greater this leverage, the greater the potential for loss. 

In markets such as we now face – greater economic uncertainty, higher inflation and interest rates meaning returns are likely to be more uncertain and therefore lower for longer – derivatives can provide predictable returns with a higher probability of securing them.

For instance, we think simple derivative investments linked to the performance of one or more large, liquid equity indices have real value.

One example is a derivative instrument called an autocall.