A derivative is a financial contract that derives its value from the performance of an underlying entity, such as a physical asset or a market index.
Understanding derivatives
A derivative is an agreement between two or more parties to buy or sell a specific asset at a predetermined price on a future date. The underlying asset can be a stock, bond, commodity, currency, or interest rate. The derivative itself has no intrinsic value. Its price fluctuates based on the price movements of the asset it tracks.
Common types of derivatives include futures, forwards, options, and swaps. These instruments are traded on public exchanges or over-the-counter. Exchange-traded derivatives are standardized and highly regulated across global financial markets. Over-the-counter derivatives are private contracts customized between the trading parties. This customization introduces counterparty risk, as one party might default on the agreement.
As Elephants managing your own portfolios, you might use derivatives for hedging or speculation. Hedging involves taking a position to offset potential losses in another investment. Speculation involves betting on the future price direction of an asset to generate a profit. Because derivatives often use leverage, investors can control a large position with a relatively small amount of upfront capital. This amplifies both potential gains and potential losses.
Example
Suppose a cooperative of Elephants operates a large peanut farm and expects to harvest 10,000 kilograms of peanuts in six months. The current global market price for peanuts is $2 per kilogram. The Elephants are concerned that a surplus of peanuts will drive the price down by the time they are ready to sell. To protect their revenue, the Elephants purchase a futures contract. This derivative locks in the ability to sell their 10,000 kilograms of peanuts at $2 per kilogram in exactly six months. If the market price drops to $1.50 per kilogram at harvest time, the Elephants still sell their crop at the $2 contract price, successfully hedging against the price decline. If the market price rises to $3 per kilogram, the Elephants are obligated to sell at the $2 contract price and miss out on the higher market rate.