Financial Derivatives: What Are They And How Do They Work? (2024)

Derivatives are complex financial contracts based on the value of an underlying asset, group of assets or benchmark. These underlying assets can include stocks, bonds, commodities, currencies, interest rates, market indexes or even cryptocurrencies.

Investors enter into derivative contracts that clearly state terms for how they and another party will respond to future changes in value of the underlying asset.

Derivatives may be traded over-the-counter (OTC), meaning an investor purchases them through a brokerage-dealer network or on exchanges like the Australian Securities Exchange (ASX), which offers various derivative trading options.

While exchange-traded derivatives are regulated and standardised, OTC derivatives are not. This means that there’s potential for higher profits but also increased risk from counterparty default, where one party may fail to fulfil the derivative contract terms.

You’re most likely to encounter four main types of derivatives: futures, forwards, options and swaps. As an everyday investor, particularly in the Australian market, you’ll probably only ever deal directly with futures and options, though.

Futures

With a futures contract, two parties agree to buy and sell an asset at a set price on a specified future date.

Futures contracts are used to mitigate the risk of an asset’s price fluctuation, ensuring that neither party suffers a significant loss or pays an excessive markup. These contracts lock in a rate that seems acceptable based on current information.

Futures are standardised and traded on exchanges, such as the ASX, making them accessible to everyday investors, similar to stock purchases. They allow for daily settlement of gains and losses, enabling speculation on short-term price movements without the commitment to the full duration of the contract.

The exchange traded nature of futures reduces the risk of contract default.

Forwards

Forward contracts are very similar to futures contracts in that they involve an agreement to buy or sell an asset in the future, except they are set up OTC, meaning they’re generally private contracts between two parties. This means they’re unregulated, much more at risk for default and something average investors wouldn’t generally put their money towards.

While they introduce more risk into the equation, forwards do allow for much more customisation of terms, prices and settlement options, which could potentially increase profits.

Options

Options contracts provide the right, but not the obligation, to buy or sell an asset at a predetermined price within a specific timeframe.

Options are like non-binding versions of futures and forwards: They create an agreement to buy and sell something at a certain price at a certain time, but the party buying the contract is under no obligation to use it. Because of this, options typically require you to pay a premium that represents a fraction of the agreement’s value.

Options can be American or European, which determines how you can enact them.

European options are non-binding versions of a futures or forward contract. The person who bought the contract can enforce the contract on the day the contract expires—or they can let it go unused.

American options, meanwhile, can be enacted at any point leading up to their expiration date. They are similarly non-binding and can go unused.

Options can trade on exchanges or OTC. When they are traded on an exchange, like the ASX, options are guaranteed by clearing houses and are regulated, which decreases counterparty risk.

Like forwards, OTC options are private transactions that allow for more customisation and risk.

Swaps

Swaps allow two parties to enter into a contract to exchange cash flows or liabilities in an attempt to either reduce their costs or generate profits. This commonly occurs with interest rates, currencies, commodities and credit defaults, the last of which gained notoriety during the 2007-2008 housing market collapse, when they were overleveraged and caused a major chain reaction of default.

The exact way swaps play out depends on the financial asset being exchanged. For the sake of simplicity, let’s say a US company enters into a contract to exchange a variable rate loan for a fixed-rate loan with another company. The company getting rid of its variable rate loan is hoping to protect itself from the risk that rates rise exponentially.

The company offering the fixed rate loan, meanwhile, is making a bet that its fixed rate will earn it a profit and cover any rate increases that come from the variable rate loan. If rates go down from where they currently are, all the better.

Swaps carry a high counterparty risk and are generally only available OTC to financial institutions and companies, rather than individual investors.

Known for their complexity, derivatives aren’t generally used as straightforward buy-low-sell-high or buy-and-hold investments. Instead, parties involved in a derivative transaction may be using them to:

• Hedge a financial position. If an investor is concerned about where the value of a particular asset will go, they can use a derivative to protect themselves from potential losses. This is particularly relevant in volatile markets or with investments heavily influenced by economic factors.
• Speculate on an asset’s price. If an investor believes an asset’s value will change substantially, they can use a derivative to make bets on its potential gains or losses. This approach is often seen with assets like stocks, commodities and even currencies like the AUD.
• Use funds more effectively. Most derivatives are leveraged, requiring you to put up a fraction of the contract value as collateral. This is helpful when you’re trying to spread money out across many investments to optimise returns without tying a lot up in any one place, and it can also lead to much greater returns than you could get with your cash alone. But it also means that you may be open to immense losses if you make the wrong bet with a derivatives contract as every move is amplified with leverage.

Derivatives can be incredibly risky for investors. Potential risks include:

• Counterparty risk. The chance that the other party in an agreement will default can run high with derivatives, particularly when they’re traded OTC. Because derivatives have no value in and of themselves, they’re ultimately only worth the trustworthiness of the people or companies who agree to them.
• Changing conditions. Derivatives that contractually obligate you to certain prices can lead to riches—or ruin. If you agree to futures, forwards or swaps, you could be forced to honour significant losses, losses that may be exacerbated by any leverage you took on. Even non-obligatory options aren’t without risk, though, as you must put forth some money to enter into contracts you might not choose to execute.
• Complexity. For most investors derivatives, particularly those accustomed to straightforward investment strategies, the complexity of derivatives can be daunting. These financial instruments often demand a deep understanding of the market and active management, differing significantly from traditional passive investment approaches.

Derivative investing is a high-risk venture and generally not advisable for beginners or even intermediate investors. It’s crucial to have a deep understanding of financial markets and a backup plan, like an emergency fund and retirement contributions, before you delve into more speculative investments, like derivatives. And even then, you won’t want to allocate substantial portions of your savings to derivatives.

That said, if you’d like to get started with derivatives in Australia, you can easily do so by purchasing fund-based derivative products using a typical investment account.

You might consider, for instance, a leveraged managed fund or an exchange-traded fund (ETF), which can use options or futures contracts to increase returns, or an inverse fund, which uses derivatives to make investors money when the underlying market or index declines.

Fund-based derivative products like these help decrease some of the risks of derivatives, like counterparty risk. But they also aren’t generally meant for long-term, buy-and-hold investing and can still amplify losses.

If you want more direct exposure to derivatives, you may be able to place options and futures trades as an individual investor. Not all brokerages in Australia offer derivatives, so if you wish to trade these volatile instruments, be sure your trading platform allows it.