What are derivatives? Derivatives often sound like something only finance pros should understand. In reality, the basic idea is easier to grasp than you might expect. These contracts may be complex in practice, but we hope that by the conclusion of this article, you’ll see they’re built on a straightforward principle: their value comes from something else.
In this guide, we’ll explain derivatives in plain English. We’re going to cover how they work, the main types of derivative contracts, where they are traded, why people use them, and what risks come with them. By the end, you’ll have a working knowledge of one of finance’s most discussed tools.
What are Derivatives?
At their core, derivatives are financial contracts that “derive” their value from an underlying asset. That asset could be a stock, a bond, a commodity like oil or wheat, or a currency. It could even be something less traditional, like an interest rate or a weather index.
The derivative doesn’t involve owning the asset itself. Instead, it’s a contract about the asset’s price, performance, or outcome.
Picture this: a farmer makes a deal now to sell wheat at today’s price, even though the actual sale won’t happen until months later. The contract’s value changes as wheat prices rise or fall. That deal is a derivative: its worth depends on the future value of wheat, not on directly holding the wheat itself.
What Makes Derivatives Complex Financial Instruments?
Much of what makes derivatives complex is that they have numerous moving parts. In fact, derivatives entail a lot more than just buying or selling something outright.
Some of their moving parts include:
Expiration dates
Contract terms
Counterparties
Leverage (sometimes)
Their pricing often concerns formulas and assumptions that go beyond what most people encounter in everyday financial products.
Still, the core idea remains uncomplicated: the derivative follows the price of something else. If the underlying asset goes up, the derivative usually gains value. If it goes down? Then, the derivative usually loses value.
The Vital Role of the Underlying Asset
Every derivative depends on an underlying asset. Without it, the contract wouldn’t exist.
The underlying could be:
A commodity (oil, gold, corn, cotton, etc.)
A financial instrument (stocks, bonds, etc.)
A currency pair (CAD versus USD, for example)
An index (S&P 500, Dow Jones Industrial Average, etc.)
The underlying asset acts as the reference point. For example, a gold futures contract doesn’t involve owning physical gold bars. Rather, it’s an agreement whose value rises or falls with the market price of gold.
4 Main Types of Derivative Contracts
There isn’t just one kind of derivative. Although there are many varieties, the most common are futures, forwards, options, and swaps. Let’s talk about those next.
Futures Contracts
Futures contracts are agreements to buy or sell an asset at a set price on a specific future date. These are standardized contracts traded on exchanges.
Standardization means everyone deals with the same size, dates, and rules. A futures contract for corn, for instance, might always cover 5,000 bushels, expiring in March, June, September or December.
Because futures are traded on regulated exchanges, they’re easier to buy and sell and carry less risk of default. Farmers, airlines, and investors all use futures to manage price changes in commodities and financial markets.
Forward Contracts
A forward contract works like a futures contract but is privately negotiated. This makes it an OTC derivative, meaning it’s traded directly between two parties instead of on an exchange. Forwards are highly customizable, which can be advantageous. That said, they also involve more risk if one party fails to deliver.
Imagine a bakery agreeing with a farmer to buy wheat in six months at today’s price. That is a forward contract. The bakery gains certainty on costs, while the farmer locks in revenue.
Options Contracts
Options give the holder the right, but not the obligation, to buy or sell an asset at a fixed price within a certain time.
A call option is the right to buy.
A put option is the right to sell.
Let’s say a stock is worth $50; a call option to buy it at $55 within three months might cost $2. If the stock rises to $65, the option is valuable, because you can buy at $55 and sell at $65. Now, if the stock stays below $55, you let the option expire, losing only the $2 paid.
Options are widely used to hedge stock investments or to speculate on price moves with limited upfront costs.
Swaps
Swaps are agreements to exchange financial obligations. The most common are interest rate swaps and currency swaps.
Imagine a company paying variable interest on a loan that swaps with another company paying fixed interest. This way, each benefits from the terms they prefer.
Swaps are almost always OTC derivatives, customized for the parties involved. While less familiar to individuals, they are really common in the corporate finance world.
Standardized Contracts vs. OTC Derivatives
The distinction between standardized contracts and OTC derivatives is important.
Standardized contracts (like futures and options) trade on exchanges. They have uniform terms and are backed by clearinghouses that reduce the risk of default.
OTC derivatives (like forwards and swaps) are private deals. They can be customized, but involve counterparty risk (AKA: the danger that the other party won’t fulfill their promise).
After the 2008 financial crisis, regulators pushed to move more OTC derivatives onto exchanges to increase transparency and reduce systemic risk.
How Derivatives Trading Works
Derivatives trading can happen on exchanges or in private markets. Exchange-traded derivatives are easier for individuals to access through their brokerage accounts, while OTC trading is mainly for institutions.
Traders post margin (a percentage of the contract’s value) instead of paying the full amount. This creates leverage. With a small upfront amount, you can control a large position. While leverage can magnify gains, it also magnifies losses.
Why Do People Use Derivatives?
Derivatives serve two main purposes: hedging and speculation.
Hedging
You’ve likely heard the term “hedging your bets” before, and hedging means using derivatives to reduce risk.
A farmer hedges against crop price drops. An airline hedges against rising fuel costs. An investor buys a put option to protect their stock portfolio from market declines. Hedging is about gaining certainty, even if it means giving up some potential profit.
Speculation
Speculators use derivatives to bet on price movements. Consider a trader who might believe oil prices will rise and buy oil futures. If they’re right, they profit without ever storing a barrel of oil. Speculation introduces more risk but can also create opportunities for large returns.
Benefits of Derivatives
Despite their somewhat intimidating reputation, derivatives serve some incredibly practical purposes.
For businesses, they provide ways to manage uncertainty around costs and revenues. As for investors, derivatives can open doors to markets or strategies that would otherwise be out of reach.
In short, derivatives can play a valuable role in keeping financial systems running smoothly, provided they’re used with care.
Here are some of the most notable benefits:
Risk management: They allow businesses and investors to lock in prices and reduce uncertainty.
Market access: Derivatives make it easier to invest in assets that might be hard to trade directly, like indexes or currencies.
Capital efficiency: With leverage, investors can participate in markets with less upfront money.
Liquidity and price discovery: Derivatives help determine fair prices in markets by bringing together hedgers and speculators.
Risks of Derivatives
While the advantages of derivatives are consequential, they come with trade-offs we can’t ignore. The very features that make derivatives appealing (like leverage and flexibility) can also make them dangerous if they’re misused or misunderstood.
History has shown that overreliance on complex contracts without proper oversight can lead to widespread financial consequences.
For instance, during the 2008 global financial crisis, many large banks and investment firms held massive amounts of mortgage-backed securities and credit default swaps, both types of derivatives tied to the housing market.
When U.S. home prices began to fall and mortgage defaults surged, the value of these contracts collapsed. Because they were traded in huge volumes and often lacked transparency, the losses spread quickly through the financial system. Ultimately, some institutions failed, triggering one of the worst recessions in modern history.
Here are a few of the risks to keep in mind:
Leverage risk: Losses can exceed initial investments when trades move in the wrong direction.
Complexity: Many derivatives require advanced knowledge to understand.
Counterparty risk: OTC derivatives depend on the reliability of the other party.
Systemic risk: Misuse of derivatives can destabilize financial systems, as seen in 2008.
Derivatives are not tools for casual investing without education. Even professional investors must carefully manage risk when using them.
Continue Your Financial Learning with iCash
Understanding derivatives is a big step toward building up your financial literacy. While these contracts may seem intimidating, knowing the basics helps you see how they influence prices and risk management across industries.
At iCash, we’re committed to helping Canadians improve their financial confidence and their financial position. From everyday money management to understanding complex financial instruments, we offer a selection of tools and resources to support better decisions.
If you need short-term financial help, iCash offers fast and secure payday loans online. Our application process is uncomplicated, and funds can be sent quickly to help cover urgent expenses.
Derivatives: FAQs
Still curious about this financial concept? We cover some of the most common questions on the topic below:
What is a derivative in simple words?
A derivative is a contract whose value depends on another asset, like a stock or commodity. You don’t own the asset itself, but you agree on trades related to its future price.
What is the underlying asset in a derivative?
The underlying asset is the reference point for the derivative. This might be oil, a stock, a currency, or even an index. The derivative’s value changes with the price of that asset.
What are common types of derivatives?
The most common types are futures contracts, forward contracts, options, and swaps. Each has different rules, but all derive value from an underlying asset.
Are derivatives risky?
Yes, inherently so. Derivatives involve leverage, market risk and sometimes counterparty risk, too. While they can reduce risk when used for hedging, they can also lead to substantial losses when used for speculation.
Why are derivatives important?
Derivatives support modern financial markets by helping businesses stabilize costs and by giving investors tools to manage or take on risk. They play a role in everything from farming to international trade.
