Derivatives

Derivatives, or derivative financial instruments, are contracts that are usually concluded between a seller and a buyer in relation to an underlying asset. They are called “derivatives” because the cost of such an instrument depends on the price of the underlying asset. Under these contracts, parties have rights and/or obligations related to transferring a portion of the underlying asset.

In simple terms, a derivative is a contract under which the parties can obtain the right to transfer an asset under certain conditions. Often, such a transfer will be carried out in the future, after the completion of the contract. Such contracts are called fixed-term contracts, and they are traded on fixed-term markets. The underlying asset for derivatives can be almost anything that is traded on the financial market.

Depending on the underlying asset, derivative financial instruments may be presented at the auction, for example:

• Commodity derivatives, where the underlying assets are commodities.
• Currency derivatives, where the underlying asset is a currency or its exchange rate.
• Credit derivatives, based on debt instruments (and this is the only type of derivatives that are usually traded over-the-counter, not on an exchange).
• Equity derivatives, based on stocks, bonds, or other securities.
• Interest rate derivatives, where the underlying asset is the interest rate.

Derivatives Market

The derivatives market is a futures market where the following types of contracts are concluded:

• Futures — the essence of such contracts is that the price for the goods that will be delivered in the future is fixed now.
• Forwards — similar to futures, but allow the parties to add additional conditions, such as time and place of delivery, packaging, and transportation. Another important difference between forwards and futures is the settlement procedure. For futures, settlement can occur daily or at contract expiration; for forwards, settlement usually occurs at the contract’s maturity. Forwards are concluded over-the-counter.
• Swaps are derivative financial instruments used to exchange cash flows or financial instruments. Swaps can be used to hedge risk or manage exposure and are not necessarily traded on an exchange.
• Options are similar to futures but differ in the rights and obligations of the parties. The buyer of an option has the right, but not the obligation, to execute the contract, while the seller has the obligation if the buyer chooses to exercise it.

The derivatives market can be exchange-traded or over-the-counter.

• Exchange-traded derivatives — transactions are concluded with a central counterparty, and trading is conducted with standardized contracts regarding execution dates and volumes. Only futures, options, and swaps are usually traded.
• Over-the-counter derivatives — there are almost no standards for contract parameters. All types of derivatives can be traded here.

How Can Derivatives Be Used in Trading?

Derivative financial instruments perform a number of functions, such as risk management, price forecasting, and obtaining operational benefits.

There are four groups of participants in the derivatives market:

• Hedgers — participants who aim to reduce risks or obtain insurance against negative events with the underlying asset. For example, a hedger may buy shares and sell futures for the same volume; if the stock falls, a rise in the futures price can offset losses.
• Arbitrageurs — earn from price differences for the same instrument on different platforms or similar instruments. For example, they can work with fixed-term contracts with different deadlines.
• Speculators — engage in the riskiest activities, buying or selling assets or financial instruments, hoping that the price will move favorably in the future.
• CFD traders — speculate on price movements without owning the underlying asset, often using leverage.

The Pros and Cons of Derivatives

Advantages include:

• Can be used to reduce financial risks.
• Allow trading with leverage to increase investment profitability.
• Expand the set of trading strategies when included in an investment portfolio.

Disadvantages include:

• Increased risks when using leverage.
• Higher volatility compared to the underlying asset.
• Increased legal vulnerability of over-the-counter derivatives in some jurisdictions, as they may be classified as speculative contracts with limited legal protection.