Derivatives
ES: Derivados PT: Derivativos
Contracts whose value depends on something else: the four families that exist, what they were invented for, and why leverage makes them useful and dangerous at the same time.
What They Are and Where They Come From
A derivative is a contract whose value derives from the behaviour of something else: a share, an index, a commodity, an interest rate, a currency, even the weather. It has no value of its own; it borrows it from the underlying. Derivatives were born to solve a very specific and very old commercial problem: a farmer wants to lock in today the price of the harvest they will sell in six months, and a miller wants to lock in today the price they will pay. A contract fixing that price in advance benefits both because it removes uncertainty. The nineteenth-century forward contracts on grain at the Chicago exchange are the direct ancestor of the modern market, and that function of risk transfer remains the reason the whole edifice exists.
The Four Families
Forwards are bilateral agreements, negotiated bespoke between two parties outside any organised market; flexible, but carrying counterparty risk, because nobody guarantees the other side will perform. Futures are standardised, exchange-listed forwards, with a clearing house interposed between the parties that all but eliminates counterparty risk in exchange for requiring margin and marking to market daily. Options differ from both because they grant a right, not an obligation, which produces an asymmetric profile: capped loss for the buyer. And swaps exchange streams of payments — fixed rate for floating, one currency for another, an asset’s return for a rate — and are the dominant instrument by volume, though the least visible to the retail investor.
What They Are Actually Used For
Three economic functions, with different participants in each. Hedging is the original one: an airline fixing the price of fuel, an exporter locking in an exchange rate, a fund protecting a portfolio. Speculation provides the counterparty that makes hedging possible: without someone willing to take on the risk the hedger wants to shed, there would be no market; the speculator is paid to take it. And arbitrage keeps prices coherent across related instruments: when a future drifts from what spot plus cost of carry implies, or an option breaks put-call parity, someone exploits it and the discrepancy disappears. All three are necessary; removing any one would degrade the functioning of the other two.
Leverage, Which Is the Key to Everything
The feature that defines how a derivative behaves is that it lets you control a large exposure with a small outlay. An E-mini S&P futures contract controls a notional of several hundred thousand dollars on margin of a few thousand. An option on a hundred shares costs a fraction of the price of those shares. That capital efficiency is exactly what makes derivatives useful for hedging — it lets you protect a lot while spending little — and exactly what makes them dangerous when used to speculate without sizing properly. The rule that summarises decades of accidents is brief: size by the notional value you control, never by the margin the broker locks up. Confusing the two figures is the technical cause of most individual blow-ups in these markets.
Their Own Risks, and the Role of Clearing
Beyond market risk, derivatives carry risks the underlying does not. Counterparty risk — that the other side does not pay — is the whole reason clearing houses exist, and its absence in the over-the-counter credit derivatives market was a central factor in the 2008 crisis. Liquidity risk appears in distant expirations or secondary products, where the bid-ask spread makes getting in or out unworkable. Model risk arises when valuation depends on assumptions — normality, stable correlations — that stop holding precisely in the extreme scenario. And operational risk includes unanticipated assignments, physical deliveries not managed in time, and adjustments from corporate actions that alter the contract.
The Four Families of Derivatives
| Instrument | Nature | Where it trades | Counterparty risk |
|---|---|---|---|
| Forward | Bespoke obligation | Bilateral, off-exchange | High: no guarantor |
| Future | Standardised obligation | Organised exchange | Very low: clearing house |
| Option | A right, not an obligation | Exchange or bilateral | Low on an exchange |
| Swap | Exchange of payment streams | Mostly bilateral, increasingly cleared | Moderate, depends on clearing |