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What are derivatives?

What are derivatives? In this article, Dr Hong Bo explains their role and their importance, and why they exist.
Exterior of New York Stock Exchange
© CC0 Public Domain

What are derivatives?

Derivatives are financial contracts that relate to future transactions of an underlying asset (either a tangible, durable commodity or a financial asset). Put simply, derivatives derive or depend on something else.

Financial derivatives

Financial derivatives have no value in themselves. However, they are traded on a derivatives market, where their market value will fluctuate depending on the market performance of the underlying asset.

Investors watch the movement of the spot market of the underlying asset, and form expectations about its future performance, and based on this they decide whether or not to participate in the derivatives market.

Players in the financial derivatives market

Players in the financial derivatives market include speculators and hedgers. Hedgers are using derivatives to reduce risks concerning price changes in future transactions of the underlying asset, whereas speculators bid against the changes in the market price of derivatives to make short-term profits.

Hedgers are often suppliers of commodities or people who have a demand for commodities, whereas speculators aren’t generally concerned about commodities themselves.

The most common types of financial derivatives are futures, options and swaps.

Why does a market for financial derivatives exist?

So, why does a market for financial derivatives exist? The simple reason is that people have different expectations of the performance of the underlying assets.

For example, if you want to sell an asset in the spot market after three months, you will naturally be concerned about the price of the asset at the end of the third month.

If you expect that the market price of the underlying asset will decrease at this time, selling the asset in the spot market at the end of the third month will reduce the profit you make on the sale, or cause you to make a loss.

Protecting yourself

To protect yourself against potential losses, you can use derivatives, eg, futures and options, to hedge or reduce your risk. If you are a hedger, you watch the movement of the spot market of the underlying asset, based on which you form an expectation of the future price of the underlying asset.

Keeping an eye on the movement of the market

On the other hand, if you are a speculative investor, you also keep an eye on the movement of the spot market of the underlying asset because you need to forecast which direction the market price of the derivatives written on this underlying asset is going to go.

Therefore, the derivatives market is underpinned by market players’ differing expectations about the future performance of an asset, and also by the quality of the information these investors use to form their expectations.

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Risk Management in the Global Economy

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