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Financial contracts whose value is linked to the value of an underlying asset

What are Derivatives?

Derivatives are financial contract whose value is linked to the value of an underlying asset. They are complex financial instruments that are used for various purposes, including hedging and getting access to assets or markets.






History of Derivatives



Types of Derivatives


1. Forwards and futures



2. Options

They provide the buyer of the contracts the right but not the obligation to purchase or sell the underlying asset at a predetermined price. Based on the option type, the buyer can exercise the option on the maturity date (European options) or on any date before the maturity (American options).


3. Swaps



Advantages of Derivatives

Unsurprisingly, derivatives exert a significant impact on modern finance, because they provide numerous advantages to the financial markets:


1. Hedging risk exposure

Since the value of the derivatives is linked to the value of the underlying asset, the contracts are primarily used for hedging risks. For example, an investor may purchase a derivative contract whose value moves in the opposite direction to the value of the asset. In addition, it can be utilized to reallocate risk from risk-averse players to risk-seeking players.


2. Underlying asset price determination



3. Market efficiency



4. Access to unavailable assets or markets

Derivatives can help organizations get access to unavailable assets or markets. By employing interest rate swaps, a company may obtain a more favorable interest rate relative to interest rates available from direct borrowing.


Disadvantages of Derivatives

Despite the benefits that derivatives bring to the financial markets, the financial instruments come with some significant drawbacks. The drawbacks resulted in disastrous consequences during the financial crisis of 2007-2008. The rapid devaluation of mortgage-backed securities and credit-default swaps lead to the collapse of financial institutions and stock markets around the world.


1. High risk

While the high volatility of the derivatives exposes them to potentially huge losses, the sophisticated design of the contracts makes the valuation extremely complicated or even impossible. Thus, they bear the high inherent risk.


2. Speculative features

Derivatives are widely regarded as a tool of speculation. Due to the extremely risky nature of the financial instrument and their unpredictable behavior, the unreasonable speculation may lead to huge losses.


3. Counter-party risk

Although derivatives traded on the exchanges generally go through a thorough due diligence process, some of the contracts traded over-the-counter do not include a benchmark for due diligence. Thus, there is a high probability of counter-party default.


Related Readings

CFI is the official provider of the Financial Modeling & Valuation Analyst (FMVA)™ designation for financial analysts. From here, we recommend continuing to build out your knowledge and understanding of more corporate finance topics such as:

  • Futures Contract
  • Guide to Commodities Trading
  • Hedging Arrangement
  • New York Mercantile Exchange (NYMEX)

Corporate Finance Training

