All derivatives contracts derive their value from the price of one or more underlying assets. But while a huge range of instruments can be used as underlying, the majority of derivatives products tend to be based on five broad underlying asset classes. Read on for a closer look at the different classes and examples of their associated products.
The most commonly utilized equity derivatives securities are either futures or options on broad equity indices. This trend dates all the way back to 1982, when futures trading began on the Chicago Mercantile Exchange based on Standard & Poor’s composite index of 500 stocks; the following year, futures options began trading. Since that time, the trend has grown exponentially, and today, most international financial centers offer futures based on benchmark stock indices. These are highly useful hedging tools for investors, as they enable the purchase of a stock index for a certain price on a certain date, thus allowing investors to protect portfolios that are held over the long-term as part of an ongoing strategy.
Beyond equity futures, another popular equity derivative is the equity swap. Under this form of contract, an investor pays a counterparty the total return on a stock in exchange for a floating interest rate. This allows an investor to hedge an equity position without having to give up share ownership; likewise, the counterparty receives the benefit of exposure without having to take on share ownership.
Interest rate derivatives
Commonly used by banks as a way of managing interest rate risk, an interest rate swap involves payments from a bank to a counterparty based on a floating rate, in exchange for which the bank receives fixed interest rate payments. This type of swap helps banks reduce their exposure to interest rate risk by avoiding or minimizing the impact of situations in which a decline in market interest rates reduces a bank’s income from interest, but not the interest payments owed on deposits.
Interest rate futures contracts are another popular type of interest rate derivatives, allowing buyers to lock in a future investment rate for up to 24 months out. They also serve as a useful gauge of the market expectations around future US financial policy decisions.
Although early derivatives markets (dating back to the time of ancient Rome) were almost exclusively commodities-based, the development of modern-day commodity derivatives markets began as recently as the 1970s. These years saw the breakup of the dominance that a small handful of large commodity producers previously held over the market, thus allowing the market conditions of supply and demand to be better reflected in price movements. Given the resulting spot market price volatility, demand increased for commodity derivatives trading as a way of hedging the associated price risks. One of the earliest types of commodity derivatives to become popular was forwards contracts on crude oil, particularly after the rise of OPEC. Deregulation in the US energy sector also encouraged trading of natural gas and electrical power futures in the 1990s.
Foreign exchange derivatives
Given the increasing globalization of finance and trade, demand has risen in recent decades for protection against exchange rate movements. As a hedging tool, forward exchange contracts are hugely popular; essentially, this type of contract is an obligation to sell or buy a particular amount of foreign currency on a certain future date at an agreed-upon rate of exchange.
Cross-currency swaps are another much-used type of foreign exchange derivative. In a cross-currency swap, two parties exchange payments of both principal and interest in different currencies. For the development of local currency bond markets, it is important to have a liquid cross-currency swap market, as these instruments permit foreign borrowers in local bond markets to hedge against the interest rate risk involved in swapping back proceeds to their own currencies.
The basic breakdown of a credit derivative is the promise of payment from one party (the credit protection seller) to another (the credit protection buyer), which is contingent on a credit event occurrence. In this case, a credit event is a broad term referring to any incident that affects a financial instrument’s cash flows, such as a bankruptcy filing or a failure to pay.
Credit default swaps (CDS) have grown rapidly over the past decade to become the most popular type of credit derivative. Essentially, this kind of swap is an insurance policy that protects the buyer from losing principal on a bond in the event of a default by the bond issuer. Over the life of the contract, the CDS buyer pays a periodic premium to the seller, the premium being a reflection of the buyer’s assessment of the likelihood of default and the expected loss that would arise in that event. If a credit incident occurs, a CDS gives the buyer the right to compensation from the seller.