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The 4 Most Common Types of Derivatives

The world of investing has become larger and larger, with many other ways to invest popping up like mushrooms. Among these mushrooms are derivatives, which are used in many ways.

You may have heard of the word derivatives before, but are you familiar with what they really are? Do you know how derivatives work?

Derivatives have been around for decades, especially if you look at the farming sector. Sometimes a farmer enters into a contract with a person to sell his harvests. The sale will take place at a specific future time and future price.

derivatives embedded on top of blurred letters

There are many kinds of derivatives, and we’re here to tackle the 4 most common types. But before we do that, let’s first have a quick look at the jargon.

Terms and Words Relating to Derivatives

This will be very quick but it’s very important. Don’t skip it!

In general, derivatives can be quite difficult to understand. It’s partly because these contracts have a unique language.

Many derivative instruments have counterparties. And these counterparties take the opposing side of each other to make a trade.

Each derivative contract sports an underlying asset that basically dictates pricing, risks, and term organization. Basically, if the underlying asset is expensive and risky, so is the contract. The underlying asset can be stocks, currencies, commodities, real estate properties, etc.

When it comes to pricing, the derivative may have a strike price. The strike price is the price at which the derivative may be executed.

There’s also the call price, which exists among fixed income derivatives. The call price is the price at which the issuer can convert a security.

Derivatives can compel an investor to take a bullish stance with a long position. A bearish stance would fit with a short position. Then, a neutral stance can better suit a hedged position that might include both short and long features.

(Related: Bull and Bear Markets: Breaking Down the Differences)

Now that you know the important terms to remember, let’s dig into the different kinds of derivatives you can trade.

Forward Contracts

You may say that forward contracts are the simplest form of derivatives out there and it’s the oldest. In its purest form, a forward contract is merely an agreement to sell something on a future date. The price, however, comes up at the present. The parties involved in the contract decide about the price the moment they strike the agreement.

Here’s something you have to remember: forward contracts exist between two counterparties. This means that there’s no exchange acting as an intermediary between them. Therefore, you got to shoulder higher counterparty risks. If these contracts need to reverse before expiring, the terms may no longer be favorable for the parties.

(Related: The World’s 13 Major Stock Exchanges You Should Know About)

Futures Contracts

This one’s very similar to the first type. It also enables two parties to agree on a price now and execute the trade at some later time.

The difference lies on the fact that futures contracts exist on the exchange, which acts as the intermediary. When contracts exist on exchanges, they have a standardized nature. This means neither you nor the other party can modify the contract in any way.

The reason is that exchange contracts have predetermined formats, sizes, and expirations. These contracts also have to follow a settlement procedure on a daily basis. You and the other party should settle any gains or losses on the contract on any given day. The benefit of doing this is the negation of any counterparty credit risk.

Overall, you need to remember that you are dealing more with the exchange than with the other party.

Options Contracts

Options contracts are quite different from the first two types of derivatives. In the first two, both the parties should deliver what the contract says. They should buy and sell a certain asset on a certain price.

The options contract, on the other hand, only binds one of the parties to the duties. The other party, meanwhile, has the right to execute the trade but not the obligation to do so.

There exist two kinds of options on the market: call options and put options.

Call options grant you the rights and the choice to buy an asset on a future date at a predetermined price.  Put options, meanwhile, give you the rights but not the obligation to sell an asset.

Overall, you have a total of 4 choices. You can either go long or short on either call or put options. And just like futures, options also exist on the exchange.

Swaps

This fourth kind of derivative is probably the most difficult one. Swaps enable investors to exchange their cash flows or other variables linked with other investments.

Most of the time, a swap takes place because one party has a comparative advantage. A comparative advantage can be something like having the ability to borrow funds under variable interest rates.  Meanwhile, another party can borrow more flexibly at fixed rates.

There’s a so-called “plain vanilla” swap, which is the simplest form of swaps. Then, there are others that are not quite simple. Here are some of them:

  • Interest Rate Swaps: In this kind of swap, parties can exchange a fixed rate loan for a floating rate loan. If one of the parties sports a fixed rate loan but doesn’t have floating rate risk, he or she can have a swap with another party. The other party should then have floating rate to match liabilities. You can also enter interest rate swaps through option strategies. Meanwhile, a “swaption” enables you as the owner the right but not the obligation to enter into a swap.
  • Currency swaps: In this kinds of swap, one party can exchange loan payments and principal in one currency for payments principal in another currency.
  • Commodity swaps: This is a contract where two parties agree to exchange cash flows that are dependent on the price of an underlying commodity.

The Risks Involved in Trading Derivatives

Even if derivatives are considered to be powerful financial instruments, they still have their fair share of risks. And because of that, a lot of market participants are halfhearted when investing in derivatives.

Wooden word blocks spelling RISK in front of a wooden ruler on a wooden table

Some people think that since derivatives aren’t quite new instruments, what new risk could they really pose?

The opposition agrees with the statement. However, they stress that derivatives can in fact concentrate a lot of risks in a way that the system cannot absorb them easily.

Whichever of them is right, there still exist real risks when trading derivatives. Here are some of those risks.

Counterparty Risks

According to statistics, 3 out of 4 derivative contracts take place over the counter. Exchanges are not involved in these transactions. That means it’s possible that one of the counterparties may not be able to fulfill its obligations.

You can call counterparty risk many names. They can be settlement risk, default risk, legal risk, et cetera. Essentially, these risks just talk about the inability of one party to settle the contract. For example, if the parties didn’t draft the contract, you can call this a legal risk. If one party defaults on the day of the settlement, then that’s settlement risk.

Price Risk

For many investors, derivatives on exchanges are quite new. That means even the old timers do not have much clue how to do the pricing for derivatives. Remember that the market functions based on information and knowledge about the asset.

This means that the market may be mispricing the derivative contract. And this increases the possibility of a large scale default.

Agency Risk

This isn’t quite talked about in the market but it nonetheless exists. If there is a principal and an agent, the latter may not act on the best interest of the principal. This can be due to their differing goals or motivations.

This may seem like a simple problem, but cases in the past have shown just how bad this can get. A large organization lets traders make highly leverage bets on their behalf. And when that happens, you can smell trouble in the air, unless they closely monitor the traders.

Systemic Risk

This is quite a huge consideration for many traders who want to make money out of derivatives. Systemic risks pertain to the chance of a default in all financial markets started by a default in derivatives market.

In other words, investors believe that markets are so volatile that one major default can lead to cascading defaults. And when these cascading defaults go out of control, they can enter other financial domains. Eventually, they could threaten the existence of the financial system.

And though at first people refuted this as a baseless paranoia, 2008 came. And we all know what happened to the markets in 2008.

The idea behind this risk is that organization trading derivatives also have other businesses. Such businesses include large banks like Goldman Sachs and JPMorgan. If such banks take losses in the derivative market, they can expect their other businesses to receive the impact too.

Simply put, systemic risks challenge not only one party but the whole system.

Conclusion

Derivatives are very rewarding and profitable. And you have a lot of choices. Try to figure out which kind of derivative can fit your goals.  But before you do that, you have to consider your risk tolerance risk management style.

 

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