12/2/22, 12:03 Financial Derivatives: Definition, Types, Risks

US & WORLD ECONOMIES

ECONOMIC TERMS

Financial Derivatives: Definition, Types, Risks

What Makes Derivatives So Dangerous?

•••

BY
KIMBERLY AMADEO
Updated January 24, 2022
REVIEWED BY
ROBERT C. KELLY

A derivative is a financial contract that derives its value from an underlying asset. The buyer agrees to
purchase the asset on a specific date at a specific price. 

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Derivatives are often used for commodities, such as oil, gasoline, or gold. Another asset class is
currencies, often the U.S. dollar. There are derivatives based on stocks or bonds. Others use interest
rates, such as the yield on the 10-year Treasury note. 

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The contract's seller doesn't have to own the underlying asset. They can fulfill the contract by giving the
buyer enough money to buy the asset at the prevailing price. They can also give the buyer another
derivative contract that offsets the value of the first. This makes derivatives much easier to trade than
the asset itself.

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Derivatives Trading
In 2019, 32 billion derivative contracts were traded. [1]  Most of the world's 500 largest companies use
derivatives to lower risk. For example, a futures contract promises the delivery of raw materials at an

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agreed-upon price. This way, the company is protected if prices rise. Companies also write contracts to
protect themselves from changes in exchange rates and interest rates. 

Derivatives make future cash flows more predictable. They allow companies to forecast their earnings
more accurately. That predictability boosts stock prices, and businesses then need a lower amount of
cash on hand to cover emergencies. That means they can reinvest more into their business.

Most derivatives trading is done by hedge funds and other investors to gain more leverage. Derivatives
only require a small down payment, called “paying on margin.”

Many derivatives contracts are offset—or liquidated—by another derivative before coming to term. These
traders don't worry about having enough money to pay off the derivative if the market goes against
them. If they win, they cash in.

Note: Derivatives that are traded between two companies or traders that know each other
personally are called “over-the-counter” options. They are also traded through an
intermediary, usually a large bank.

Exchanges
A small percentage of the world's derivatives are traded on exchanges. These public exchanges set
standardized contract terms. They specify the premiums or discounts on the contract price. This
standardization improves the liquidity of derivatives. It makes them more or less exchangeable, thus
making them more useful for hedging.

Exchanges can also be a clearinghouse, acting as the actual buyer or seller of the derivative. That makes
it safer for traders since they know the contract will be fulfilled. In 2010, the Dodd-Frank Wall Street
Reform Act was signed in response to the financial crisis and to prevent excessive risk-taking. [2]

The largest exchange is the CME Group, which is the merger of the Chicago Board of Trade and the
Chicago Mercantile Exchange, also called CME or the Merc. It trades derivatives in all asset classes.

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Stock options are traded on the NASDAQ or the Chicago Board Options Exchange. Futures contracts are
traded on the Intercontinental Exchange, which acquired the New York Board of Trade in 2007. [3] It
focuses on financial contracts, especially on currency, and agricultural contracts, principally dealing with
coffee and cotton.

The Commodity Futures Trading Commission or the Securities and Exchange Commission regulates
these exchanges. Trading Organizations, Clearing Organizations, and SEC Self-Regulating Organizations
have a list of exchanges.

Types of Financial Derivatives

The most notorious derivatives are collateralized debt obligations. CDOs were a primary cause of
the 2008 financial crisis. [4] These bundle debt, such as auto loans, credit card debt, or mortgages, into a
security that is valued based on the promised repayment of the loans.

There are two major types: Asset-backed commercial paper is based on corporate and business
debt. Mortgage-backed securities are based on mortgages. When the housing market collapsed in 2006,
so did the value of the MBS and then the ABCP. [5]

The most common type of derivative is a swap. This is an agreement to exchange one asset or debt for a
similar one. The purpose is to lower risk for both parties. Most of them are either currency swaps
or interest rate swaps.

For example, a trader might sell stock in the United States and buy it in a foreign currency to
hedge currency risk. These are OTC, so these are not traded on an exchange. A company might swap the
fixed-rate coupon stream of a bond for a variable-rate payment stream of another company's bond.

The most infamous of these swaps were credit default swaps. They also helped cause the 2008 financial
crisis. They were sold to insure against the default of municipal bonds, corporate debt, or mortgage-
backed securities.

When the MBS market collapsed, there wasn't enough capital to pay off the CDS holders. The federal
government had to nationalize the American International Group. Thanks to Dodd-Frank, swaps are now
regulated by the CFTC.

Forwards are another OTC derivative. They are agreements to buy or sell an asset at an agreed-upon
price at a specific date in the future. The two parties can customize their forward a lot. Forwards are
used to hedge risk in commodities, interest rates, exchange rates, or equities.

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Another influential type of derivative is a futures contract. The most widely used are commodities
futures. Of these, the most important are oil price futures—which set the price of oil and, ultimately,
gasoline.

Another type of derivative simply gives the buyer the option to either buy or sell the asset at a certain
price and date.

Note: The most widely used are options. The right to buy is a call option, and the right to sell a
stock is a put option. 

Four Risks of Derivatives

Derivatives have four large risks. The most dangerous is that it's almost impossible to know any
derivative's real value. It's based on the value of one or more underlying assets. Their complexity makes
them difficult to price.

That's the reason mortgage-backed securities were so deadly to the economy. No one, not even the
computer programmers who created them, knew what their price was when housing prices dropped.
Banks had become unwilling to trade them because they couldn't value them.

Another risk is also one of the things that makes them so attractive: leverage. For example, futures
traders are only required to put 2% to 10% of the contract into a margin account to maintain ownership.
[6] If the value of the underlying asset drops, they must add money to the margin account to maintain
that percentage until the contract expires or is offset.

If the commodity price keeps dropping, covering the margin account can lead to enormous losses.
The CFTC Education Center provides a lot of information about derivatives.

The third risk is their time restriction. It's one thing to bet that gas prices will go up. It's another thing
entirely to try to predict exactly when that will happen. No one who bought MBS thought housing prices
would drop. The last time they did was during the Great Depression. They also thought they were
protected by CDS.

The leverage involved meant that when losses occurred, they were magnified throughout the entire
economy. Furthermore, they were unregulated and not sold on exchanges. That’s a risk unique to OTC
derivatives. [7]

Last but not least is the potential for scams. Bernie Madoff built his Ponzi scheme on derivatives. Fraud
is rampant in the derivatives market. The CFTC advisory lists the latest scams in commodities futures.

Frequently Asked Questions (FAQs)

What are crypto derivatives?

Crypto derivatives offer a way to speculate or hedge cryptocurrency exposure. These derivatives include
bitcoin futures traded alongside equities and commodities with the CME Group. [8] There is also an ETF
that contains bitcoin futures (BITO), and traders can trade options on BITO as another type of crypto
derivative. [9] [10]

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However, crypto derivatives can also refer to specialized futures that trade on crypto exchanges like
BitMEX. These products are similar to standard futures, but they are highly leveraged, and there are
differences in how traders' positions are liquidated. [11]

What are the types of stock derivatives?

Stock options—calls and puts—are perhaps the best-known stock derivatives, but they aren't the only
types. Other types of derivatives, like swaps and forwards, are also sometimes issued for a stock. While it
isn't technically a derivative of a single stock, traders can use futures like ES and NQ as derivatives of the
broader stock market.

ARTICLE SOURCES

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COMMODITIES
ECONOMIC TERMS Why Is Liquidity So Important in
Make Financial Markets Work for You Commodities?

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COMMODITIES
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What Is a Derivative?
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PORTFOLIO MANAGEMENT

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