Enterprise Explains: Derivative Trading. Warren Buffet famously referred to derivatives as “financial weapons of mass destruction” in a 2002 shareholder’s letter (pdf). But they’re hugely popular — and arguably the biggest asset class in the world. So what exactly are derivatives and how do we use them?

Financial derivatives defined: Put simply, a derivative is a financial instrument that derives its value from an underlying asset. When the value of the underlying asset changes, the value of the derivative changes, too. They’re primarily used for hedging against market risk, and speculating (making wagers) on changes in value to the underlying assets.

How big is the market? Hard to say, but derivatives basically have a foot in every door: The current size of the financial derivatives market is difficult to accurately estimate. Some put it as high as more than USD 1 qdrn (i.e. 1 mn bns), largely because derivatives are available on almost every asset class, including equities, commodities, bonds, currencies, oil, real estate — and even predictions about the weather.

Collectively, the total underlying value of derivatives eclipses the market value of their assets: The total notional value — or underlying value — of all contracts in the derivatives market was estimated at USD 610 tn in 2020, while the gross market value — or the price an asset would fetch in the marketplace — was around USD 15.5 tn. The reason the notional value of derivative contracts is nearly 40x higher than the market value all comes down to leverage, which is capital used to try to magnify investment results.

This allows investors to make speculative plays using derivatives with very little upfront cost — potentially bringing in substantial gains, but also magnifying potential losses. This is one reason why derivative trading is both so alluring, and — if undertaken unwisely — so risky.

There are four main types of financial derivatives: Forwards, futures, options, and swaps.

#1- Forward contracts (forwards): Forwards are the OG derivatives (they may date back to ancient Mesopotamia). Two parties who sign a forward contract agree to trade a particular underlying asset on a predetermined date (date of maturity) for a predetermined price (known as the strike). This is particularly useful for large businesses that want to hedge against changing market values for things like commodities and currencies. It allows them to lock in a price for raw materials for a future date so they can make longer-term production decisions, even amid market volatility.

Easy to customize but unregulated: Forwards don’t trade on a centralized exchange, but over-the-counter (OTC) between dealers. They’re easily customizable, making them particularly useful for hedging, but because they’re unregulated they also carry a greater degree of default risk than other instruments.

#2- Future contracts (futures): Futures are very similar to forwards, but they’re standardized, regulated, and traded on centralized exchanges. Every day, traders buy and sell mns of futures contracts on company stocks, oil and gas, gold, and a range of commodities, as this clip on derivatives explains (watch, runtime:10:48).

Egypt has its own futures exchange in the works, which last we heard is set to launch before the end of this year. In anticipation, we wrote this nifty explainer all about futures last year.

#3- Option contracts (options): An option is an agreement between two parties that allows one of them the right — but, crucially, not the obligation — to trade an asset on or before a set date, for a set price. Options can trade on exchanges or OTC. Options can be used either to hedge, or to speculate.

Put option or call option? A put option gives the seller the right to sell an underlying asset at a set date for a set price — for which the seller pays a premium. A call option gives this right to the buyer, who pays a premium. The size of these premiums is determined by a host of market-driven factors.

Swap contracts (swaps): In a swap, two counterparties exchange the cashflow of one party’s financial instrument for those of the other party’s financial instrument, for the amount of time stated in the agreement, fund manager and writer Patrick Boyle explains (watch, runtime: 17:35). This can be done with interest rates, currencies, commodities, or — most infamously — credit defaults, which many economists say helped cause the 2008 financial crisis because they were overleveraged. The exact way swaps play out depends on the financial asset being exchanged.

GO DEEPER-

• Check out fund manager and writer Patrick Boyle’s series of videos on derivatives, as well as his On Finance podcast on all things financial markets.
• Intros on everything from futures contracts to collateralized debt obligations, mortgage-backed securities, and credit default swaps: Khan Academy’s got you covered.
• Willing to pay to learn more? Coursera has a selection of courses.