Understanding the basics: derivatives
Derivatives are financial instruments whose value is linked to an underlying asset, market or benchmark. The underlying asset could be a stock index, government bond, ETF, commodity, currency or other financial instrument.
Rather than purchasing the underlying asset directly, investors can use derivatives to gain exposure to market movements, manage risk or express a view on how a market may perform in the future.
Derivatives are used across global financial markets by a wide range of participants, including individual investors, institutions and companies.
How do derivatives work?
A derivative derives its value from the performance of another asset.
For example:
- A derivative may be linked to a government bond.
- A derivative may be linked to a stock market index.
- A derivative may be linked to a commodity such as oil or gold.
- A derivative may be linked to interest rates or currencies.
As the value of the underlying asset changes, the value of the derivative may also change.
Why do investors use derivatives?
Investors use derivatives for different reasons depending on their objectives.
- Managing risk
Derivatives can be used to help manage exposure to market movements. This is often referred to as hedging.
- Expressing a market view
Investors may use derivatives when they believe a market, sector or asset class could rise or fall in value.
- Accessing markets efficiently
Derivatives allow investors to gain exposure to certain markets without directly buying the underlying asset.
- Portfolio management
Derivatives can be used alongside other investments as part of broader portfolio-management strategies.
Types of derivatives
There are several types of derivatives available across financial markets. Some of the most common include:
- Futures
A futures contract allows investors to take a position on the future value of an underlying asset.
- Options
Options provide the right, but not the obligation, to buy or sell an asset under specified conditions.
Understanding the risks
Like any investment product, derivatives carry risks.
Before trading derivatives, investors should understand:
- Market risk
- Volatility
- Leverage
- Margin requirements
- Liquidity considerations
- Contract expiry and settlement
Taking time to understand how derivatives work and the risks involved is an important part of becoming an informed investor.