Derivatives

A derivative is a contract between two parties (a bilateral contract) whose price and performance depend on an underlying asset, known as the underlying. Derivatives are used by traders, banks, companies and other institutions that are active in the financial markets. The underlying can be a security such as a share or a bond, a currency, an interest rate, a stock index, a commodity or a precious metal, or even another derivative, as with options on futures.

Derivatives have no value of their own independent of the underlying: their value is derived from it, hence the name. There is a vast range of derivatives today, used both for hedging and for speculation. With derivatives, traders can speculate on price movements without having to buy the underlying asset itself, while companies and investors can use them to protect existing positions or planned transactions against unfavourable price changes.

The two basic forms of derivatives are unconditional and conditional contracts. The key difference is whether both parties are bound by the contract or whether one of them has a choice.

Unconditional derivatives

With unconditional derivatives, also known as forward commitments, both parties are obliged to fulfil the contract: one side must buy and the other must sell the underlying at the agreed price on the agreed date, or the price difference is settled in cash. Typical examples are:

• Futures: standardised contracts traded on an exchange
• Forwards: individually negotiated contracts traded over the counter (OTC), such as the currency forwards used by companies
• Swaps: agreements to exchange payment streams, for example fixed for floating interest payments or payments in two different currencies

The risk profile is symmetrical: what one party gains, the other loses, and both sides can suffer substantial losses if the price moves against them. CFDs have a similar profile, as their value moves in line with the underlying.

Conditional derivatives

With conditional derivatives, also known as contingent claims, only one side is bound. The buyer acquires a right, but not an obligation, to buy or sell the underlying at a fixed price within a certain period or on a certain date, and decides whether to exercise it. In return, the buyer pays a premium to the seller (also called the writer), who must fulfil the contract if the buyer exercises the right. Typical examples are options and warrants, which are securitised options often issued by banks.

The risk profile is asymmetrical: the buyer's maximum loss is limited to the premium paid, while the potential gain can be considerable. For the seller, it is the other way round: the gain is limited to the premium received, while the potential losses can be very large.

Comparison at a glance