Derivatives: Contracts on Other Assets

What derivatives are, how futures, options and swaps let businesses manage risk, and why derivatives also played a role in financial crises.

A derivative is a financial contract whose value depends on, or is derived from, the price of something else, called the underlying asset. The underlying asset can be a share, bond, currency, commodity, interest rate or stock index.

Main types

Futures: agreements to buy or sell an asset at a set price on a future date, traded on exchanges. A stock index future lets investors bet on or hedge the direction of a whole market.
Options: rights to buy or sell at a set price.
Forwards: like futures but privately negotiated between two parties.
Swaps: agreements to exchange streams of payments. In an interest rate swap, one party pays a fixed rate and the other a floating rate. In a currency swap, parties exchange payments in different currencies.

Hedging

Many businesses use derivatives to manage risk, called hedging:

An airline buys fuel futures to lock in the price of jet fuel.
An exporter uses currency forwards to fix the exchange rate for payments it will receive in dollars.
A company with a floating-rate loan uses an interest rate swap to pay a fixed rate instead, making its costs predictable.

Speculation and leverage

Derivatives can also be used to speculate. Because they usually require only a small upfront payment, called margin, relative to the value of the underlying asset, they offer leverage: small price moves create large gains or losses.

The exporter's hedge

An Indian software company expects to receive 1 million dollars in three months. If the rupee strengthens, those dollars will be worth fewer rupees. The company enters a forward contract to sell the dollars at a fixed rate in three months. Whatever happens to the exchange rate, it knows exactly how many rupees it will receive, allowing it to plan salaries and costs.

Derivatives and crises

Derivatives markets are enormous, with the notional value of outstanding over-the-counter contracts measured in the hundreds of trillions of dollars, according to the Bank for International Settlements. In the 2008 financial crisis, complex derivatives tied to mortgages, and credit default swaps sold by the insurer AIG, spread losses across the financial system. Afterwards, regulators required more derivatives to be traded through central clearing houses, which stand between buyers and sellers and reduce the risk of one failure spreading.

Warren Buffett famously called derivatives “financial weapons of mass destruction” in 2002, though his company has also used them.

Thinking derivatives are only for speculation

Derivatives are widely used by ordinary businesses to reduce risk, from farmers and airlines to exporters and banks. The same tools that allow speculation also allow hedging. How they are used, and how well they are regulated, is what matters.

Key takeaways

A derivative's value depends on an underlying asset, such as a share, currency or interest rate.
Futures, forwards, options and swaps are the main types.
Businesses use derivatives to hedge risks like fuel prices, exchange rates and interest rates.
Leverage makes derivatives risky, and they spread losses in 2008, leading to central clearing reforms.