Derivatives are sophisticated financial tools that have grown in popularity in recent years. They are frequently utilised by investors, traders, and institutions for hedging or speculation purposes.
In this article, we will look at derivatives, their different types, roles, and the potential risks and rewards that come with them.
What are Derivatives?
Derivatives are financial products whose value is derived from an underlying asset or benchmark. They are simply contracts between two or more parties that allow them to speculate on or hedge against fluctuations in the underlying asset’s value without directly owning it. The underlying asset can be various financial instruments, such as equities, bonds, commodities, currencies, interest rates, or market indexes.
The value of a derivative is generated from the price changes of the underlying asset. The price of the derivative is determined by changes in the value of the underlying asset rather than by its intrinsic worth. This feature makes derivatives distinct and distinguishes them from other types of financial products.
Types of Derivatives
There are different sorts of derivatives, each having unique properties and applications. Options, futures, and swaps are some of the most prevalent types of derivatives.
Futures Contracts
Futures contracts are standardised agreements in which the buyer agrees to purchase an underlying asset, and the seller agrees to sell it at a pre-set price and date in the future. These contracts define the quantity and quality of the underlying asset. They are commonly employed in commodity markets such as oil, gold, and agricultural products or financial instruments such as stock market indices.
Options Contracts
Options contracts give the holder the right, but not the obligation, to buy (call options) or sell (put options) an underlying asset at a set price (strike price) within a given time frame. These contracts gives the holder freedom to choose whether or not to exercise the option. They are frequently used for hedging or as speculative instruments to profit from predicted price changes. Options have an expiry date and they become worthless if not executed by that expiry date. Of course, they can also be almost worthless if the strike-price is much lower (for a put option) or higher (for a call option) than the market price close to the expiry date.
Swaps
Swap contracts are designed for parties to exchange the cashflows or liabilities from two instruments. Swaps can hedge interest rates, currency, or commodity price risks. An interest rate swap, for example, allows two parties to exchange fixed and variable interest rate payments, allowing them to control their interest rate risk. For example, a swap could allow swapping your higher mortgage payments when the rate increases beyond an agreed rate on the swap contract. Of course these are tailored over-the-counter instruments that are not readily available to everyday investors.
Contracts for Difference (CfDs)
These have grown in popularity recently and are heavily aimed towards everyday investors. These contracts allow you to essentially “bet” on the movement of the asset. But unlike options, which allow you to execute the contract and purchase or sell the underlying asset, CfDs just give you a payout if you are right, or expire with no payout if you are wrong, costing you the premium.
Functions and Uses of Derivative
Derivatives serve a few functions in financial markets. Let’s look at the main functions and applications of derivatives:
Hedging
Hedging is one of the main applications of derivatives. Derivatives are used to offset potential losses or manage risks linked with underlying asset price movements. Investors can protect their money from adverse market fluctuations by holding an opposite position in a derivative contract.
Speculation
Derivatives allow speculators to profit on predicted price swings in the underlying assets. Speculators invest in derivatives based on market predictions, hoping to profit from price movements. Speculators can potentially produce big returns by utilising their grasp of market patterns and variables impacting asset pricing.
However, because of the leverage and volatility involved with these products, speculation in derivatives carries a higher risk. It necessitates a detailed examination of market conditions and a robust risk management approach.
Price Discovery
The derivatives market is an important source of information about asset pricing. Because derivative prices are derived from the underlying asset’s value, derivative market pricing and trading activity provide insights into market sentiment, expectations, and supply and demand dynamics.
What are the Benefits?
As mentioned above, risk hedging is the primary benefit offered by derivatives. However, the use of derivatives for speculation has overtaken their use for hedging over the past couple of decades. Additionally, using derivatives for risk management is not really an option for retail investors like you and me. These tailored contracts are only sold over-the-counter, meaning they are not publicly traded on the market and only available to large financial institutions.
With that said, there are numerous active funds and instruments that employ derivatives to try and boost returns, let’s explore if these are any good to investors.
Hedge Funds
First of all, it should be known that hedge funds are only available to qualified investors. These are investors who have a high net worth (>1m USD in assets) or a yearly income of 200k USD. So not really accessible to all investors. Assuming that one does meet the criteria, are hedge funds worth it? Generally, the answer would be no. Only a portion of fund managers tend to outperform the market and even those are never consistent. Additionally, hedge funds costs are extremely high, which eat into the returns heavily. You are almost always better off investing in a low cost ETF.
If interested to know more, check out this list of the top 50 hedge funds in the UK.
Mutual Funds
Mutual funds are more accessible than hedge funds as they are publicly traded. These are actively managed funds and carry higher fees than ETFs. Some mutual funds employ complicated investing strategies using derivatives. Of course, complicating the investment strategy does not guarantee better returns than the market. In fact, actively managed funds tend to trail the market after fees.
Exchange Traded Commodity (ETC)
These funds offer exposure to commodities such as oil and gold, either using actual holdings or using derivatives. When discussing these financial products, there are two factors to consider:
- The performance of commodities outside of these funds i.e. their gain in spot price over time.
- The performance of ETCs
The reason we make the distinction is because ETCs are not necessarily designed to reflect the long term performance of the underlying commodity. Additionally, we will not discuss the performance of commodities as an asset here because it is quite a complex topic that is deserving of its own article.
ETCs structured to match the performance of a commodity index will deliver just that, excluding fees. Fees for ETCs are higher than low cost ETFs but lower than hedge funds. These fees are around the 1% mark. Assuming you have an investment thesis surrounding the performance of a certain commodity, these ETCs will do the trick. However, an alternative to that would be to invest in a basket of companies with large exposure to the commodity of interest. There are ETFs for almost any commodity of interest that will cost less, pay dividends and correlate strongly with the commodity spot price.
Leveraged ETCs/ETFs
Derivatives (& debt) are used to structure leveraged ETCs and ETFs. These are designed to double or triple the gains or losses of the fund. So a 3x leveraged SPY ETF is designed to triple the gains or losses of the S&P 500 index. Needless to say, these are riskier instruments that are usually used by traders rather than long term investors. There are no alternatives to these leveraged products, but you should be careful because losses are just as boosted as gains.
Conclusion
Derivatives are complicated financial products that allow market participants to control risk and profit from market movements. However, their complexities render them too risky for retail investors. Even investing in funds that utilise these instruments charge high fees and the returns simply do not justify the costs.
Investors and traders can make informed judgements in the financial markets by understanding the fundamentals of derivatives and their implications on market prices. But it is likely more rewarding to steer away from such instruments and focus on direct ownership of quality assets in a diversified portfolio.
