Here’s Everything You Need to Know About Derivatives

Derivatives are financial contracts between two parties where the return depends on the performance of a specific underlying asset. Four common types of derivative contracts are futures, forwards, options, and swaps, and these can be based on assets like stocks, bonds, commodities, indexes, or foreign currencies.

The benefits of investing in derivatives is because they:

1. Provide exposure to different asset classes.
2. Can enhance or reduce risk.
3. May be easier to trade than the underlying asset on the contract.
4. Present a more robust picture of exposure and risk, especially in their portfolio statistics.

Many investment portfolios use these contracts to obtain exposure to asset classes, manage risk, or act on a view about the economy.

An investment portfolio can be either the buyer (long position) or the seller (short position) on a contract. Some contracts and positions provide protection and help funds reduce risk, while others are speculative and may enhance risk. Still, other contracts provide exposure similar to buying the asset itself. Derivatives also have a natural leveraging effect because the portfolio can obtain a large amount of exposure for a small upfront cost.

Derivatives have been around for decades, but they are becoming increasingly prevalent in investment portfolios globally.

Types of Derivatives

• Futures

An exchange-traded obligation to buy or sell an asset at an agreed-upon price at a specific future date. The value of the contract changes as the price of the underlying asset changes, and most contracts are settled in cash rather than in the physical exchange of goods at contract expiration.

• Forwards

Forwards refer to privately-negotiated obligations to buy or sell an asset, usually a foreign currency, at a specific price in the future. The contract size and expiration date can be customized for the portfolio’s specific needs.

• Options

Options are contracts which grant the buyer the opportunity, but not the obligation, to buy (for a call option) or sell (for a put option) a specific asset at a particular price. Option buyers have an upfront cost for a potential future benefit (they’ll only exercise the option if they can profit). In contrast, option sellers have an upfront benefit (the proceeds from the option) and a potential future cost (the obligation to sell or buy the asset at that price).

• Swaps

These are privately-negotiated contracts that allow two parties to trade different types of payments for a specific length of time. The payments can be based on a fixed interest rate, a floating interest rate, or the performance of a currency, a bond, or a stock index.

Investment Strategies for Derivatives

A simple investment strategy is to use futures as a substitute for the underlying asset, for example, buying a futures contract on a stock index instead of buying all the stocks. Generally, the return for the futures contract will be very similar to the return for the index.

A manager might use this strategy to turn a cash position into a stock-like position quickly. Bond funds regularly use futures to manage their duration.

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A more complicated strategy using futures might be a bet on the shape of the yield curve, representing bond yields with various times to maturity. The manager could buy short-term bond futures and sell long-term bond futures if he thought the yield curve might increase.

Forwards are commonly used to manage and hedge currency exposure. The gains and losses on these contracts offset currency-related fluctuations in the value of the fund’s assets. For example, a portfolio may be denominated in shillings but owns stocks denominated in dollars. A hedge can be used to mitigate the risk of shilling’s volatility against the dollar.

These derivative contracts would profit if the shilling weakens relative to the dollar, thereby offsetting the losses in the stocks’ value. Currency derivatives can also be used purely for speculation.

Options can be used to hedge a sensitive position, for example, buying a put on a stock in the portfolio to protect against price declines. Options can also be used for speculation, such as selling calls or puts, to get the extra income, hoping that the asset price doesn’t move in an unfavourable direction.

A common swap position is a fixed-for-floating swap, where the portfolio receives a fixed payment (like a bond coupon) in return for paying an amount based on a floating interest rate. A defensive swap strategy is to purchase a credit default swap on a bond already held in the portfolio. This involves regular premium payments to the counterparty, but it insures against any losses that might occur if that bond issuer were to default.

The fixed-for-floating swap can be broken down into bond and cash positions. Receiving fixed payments and paying floating is akin to receiving long bond exposure (regular fixed coupon payments) and short cash exposure (paying interest on a floating-rate loan). Buying a credit default swap reduces the portfolio’s bond exposure because it eliminates credit risk on a bond.

A   speculative strategy is to sell a credit default swap if the price for protection on that issuer seems too high relative to the risk that they might default.

Investor Benefits and Risks

Investors will benefit if the derivatives strategy is more efficient than buying or selling the underlying asset outright due to current market prices, transaction costs, taxes, or the structural advantages of these contracts. Some derivatives offer the benefit of insurance-like protection against losses. And managers that sell derivatives and manage their risk well might be able to provide additional income for investors.

Derivatives also carry certain risks—both the risks associated with the underlying asset and additional risks unique to each type of contract. One risk is that the performance of the derivative will diverge from the performance of the underlying asset.

The arbitrage process usually prevents this, although there may be short-term market conditions when the asset and the derivative behave differently. Additionally, privately negotiated derivatives have risks related to the counter- party’s ability to settle gains and losses.

The key benefits of derivatives can be summarized as follows:

1. Derivatives are much more flexible than the underlying instrument, while the value is still based on the underlying price.
2. Derivative contracts can be leveraged (or ‘geared’).
3. They can be used to insure against adverse price moves.
4. Cheaper to transact – save on transaction costs.
5. Quicker and easier to complete than a number of individual transactions.
6. Derivatives facilitate the hedging of risks.