Types of derivatives
Table of Contents
What Are derivatives?
Derivatives are financial contracts between two or more parties whose value is derived from an underlying asset, group of assets, or benchmark. These instruments can be traded either on regulated exchanges or over-the-counter (OTC), and their prices fluctuate based on changes in the underlying assets.
Common underlying assets include stocks, bonds, commodities, currencies, interest rates, and market indexes. Because derivatives are often leveraged, they carry higher potential for both profit and loss, making risk management crucial.
Popular types of derivatives include futures, forwards, options, and swaps. These instruments are typically used for hedging risk, speculating on price movements, or gaining exposure with less capital.
It's important to distinguish between hedging and speculation. When companies hedge, they aren't trying to predict future prices—they're managing existing risk. A hedge locks in margins and protects profits from adverse price movements in the underlying asset.
For example, consider a European investor who purchases U.S. stocks using U.S. dollars (USD) while their base currency is the euro (EUR). This investor is now exposed to exchange rate risk: if the euro strengthens against the dollar, any gains made in USD become less valuable when converted back to euros. To manage this risk, the investor might use a currency derivative. On the other hand, a speculator who believes the euro will rise might take a position in a derivative that profits when the euro appreciates.
What Are swaps?
A swap is a financial contract in which two parties agree to exchange cash flows or other financial instruments based on predetermined terms. These exchanges typically occur at regular intervals and are often tied to interest rates, currencies, or other benchmarks.
Interest Rate Swap (IRS)
An interest rate swap is one of the most common types of swaps. It allows two parties to exchange interest payments on a principal amount, typically to manage exposure to interest rate fluctuations.
For example, suppose Company XYZ borrows $1,000,000 at a variable interest rate, currently set at 6%. Concerned about potential rate increases—which would raise its borrowing costs—XYZ enters into a swap agreement with Company QRS.
Under the swap, XYZ agrees to pay QRS a fixed interest rate of 7%, while QRS agrees to pay XYZ the floating rate of 6% on the same notional amount. Effectively, XYZ has converted its variable-rate loan into a fixed-rate obligation.
Initially, XYZ pays QRS the 1% difference between the fixed and variable rates. If the variable rate drops to 5%, XYZ must now pay QRS a 2% net difference. If the rate rises to 8%, QRS will owe XYZ the 1% difference.
Regardless of interest rate movements, the swap provides XYZ with more predictable cash flows—achieving its objective of reducing interest rate risk.
Credit Default Swaps
A credit default swap (CDS) is a type of financial derivative that acts as a form of protection against credit risk. It is essentially a contract between two parties: the buyer, who pays regular premiums, and the seller, who promises to compensate the buyer if a borrower or bond issuer defaults on their debt. Through this mechanism, lenders and investors can transfer the risk of default to another party, much like an insurance policy.
Speculation: Since CDS contracts are tradable, investors can speculate on the creditworthiness of companies or governments. Traders may profit if they correctly predict a change in the perceived risk of default, as CDS prices fluctuate with market conditions.
Hedging: CDSs are often used as a risk management tool. For example, a bank holding corporate bonds might buy CDSs to protect itself if the bond issuer defaults. Pension funds, insurance companies, and asset managers also use CDSs to safeguard their portfolios against credit events.
Arbitrage: CDSs can also create opportunities for arbitrage. For instance, an investor could buy a bond in the cash market and simultaneously purchase a CDS on the same bond in the CDS market, taking advantage of price differences between the two. If the bond's yield minus the CDS premium is higher than the return on a risk-free bond like a Treasury, the investor effectively locks in a higher, low-risk return. Conversely, if the relationship goes the other way, traders can short the bond and sell CDS protection, profiting as the prices converge.
What Are futures?
A futures contract, or simply a "futures", is a standardized agreement between two parties to buy or sell an asset at a predetermined price on a specific future date. These contracts are traded on regulated exchanges and are commonly used for both hedging and speculation.
Futures obligate both parties to fulfill the terms of the contract upon expiration—either through physical delivery of the asset or cash settlement. The underlying assets can include commodities (like oil or wheat), financial instruments (like stock indices or interest rates), or currencies.
Hedging with Futures
For example, on November 6, 2025, Company A may purchase a futures contract for oil at $62.22 per barrel, expiring on December 19, 2025. The company expects to need oil in December and fears that prices will rise. By entering into the futures contract, it locks in the purchase price and hedges against that risk.
If oil prices rise to $80 per barrel by expiration, Company A can either take physical delivery at the lower contract price or sell the contract for a profit. Meanwhile, the seller—perhaps an oil producer—hedges against falling prices by locking in a price it is willing to sell at in the future.
In this way, both parties use the futures contract to reduce risk: the buyer protects against rising costs, while the seller protects against falling revenue.
Speculating with Futures
Unlike hedgers, speculators use futures to profit from price movements in the underlying asset—without any intention of taking or making delivery. They aim to "buy low and sell high" or vice versa by forecasting market trends.
A speculator who believes oil prices will rise might buy (go long) an oil futures contract. If the price indeed increases, they can sell (close) the contract at a higher price before expiration and pocket the difference. For example, if they buy at $62.22 and sell at $80, they earn $17.78 per barrel in profit, multiplied by the contract size (typically 1,000 barrels).
Conversely, a speculator who anticipates a price drop can sell (go short) a futures contract. If prices fall, they can buy it back at a lower price. For example, shorting at $80 and covering at $65 yields a $15 profit per barrel.
Speculators often use leverage, which allows them to control large positions with relatively small upfront capital (known as margin). This magnifies potential profits—but also amplifies potential losses.
While speculators provide liquidity to the market and help facilitate price discovery, their motivation is fundamentally different from hedgers: they seek to earn profits purely from market volatility, not to manage operational risk.
What Are Forwards?
A forward contract, or "forward", is a customized agreement between two parties to buy or sell an asset at a specified price on a future date. While forwards are similar in concept to futures contracts, the key distinction is that forwards are traded over-the-counter (OTC), not on formal exchanges.
Because they are privately negotiated, forwards can be tailored to meet the specific needs of the parties involved. This includes flexibility in terms of contract size, settlement date, and even the type of asset being traded. However, this customization also introduces certain risks.
The most significant risk in forward contracts is counterparty risk—the risk that one party may default on its contractual obligation. Since there is no centralized clearing house (as there is with exchange-traded futures), if one party becomes insolvent, the other party may suffer losses without any guarantee of compensation.
Forwards are commonly used by businesses and financial institutions to hedge exposure to price changes in commodities, currencies, or interest rates. For example, an exporter expecting to receive payment in foreign currency in three months might enter into a forward contract to lock in the exchange rate and protect against adverse currency movements.
While forwards offer flexibility, they are less liquid than futures contracts and are generally used by institutions with specific risk management needs rather than individual traders or speculators.
What Are Options?
An options contract is a financial agreement that gives the buyer the right—but not the obligation—to buy or sell an underlying asset at a specified price (known as the strike price) before or at a predetermined expiration date. This contrasts with futures contracts, where both parties are obligated to fulfill the contract terms at expiration.
Options are commonly used for both hedging and speculative purposes. They allow investors to manage risk, protect profits, or take directional views on the market with limited upfront capital.
Protective Put Example (Hedging)
Suppose an investor owns 100 shares of a stock currently trading at $50 per share. While they are optimistic about the stock's long-term value, they are concerned about potential short-term losses. To protect their position, the investor buys a put option with a $50 strike price and an expiration date in the future. This option costs $2 per share, or $200 in total (since 1 option contract typically covers 100 shares).
If the stock price falls to $40 by expiration, the investor can exercise the put option and sell the shares for $50 each—limiting their downside. Instead of losing $1,000 (100 × $10), the investor's loss is reduced to just $200—the cost of the option. This strategy is known as a protective put and is often used to hedge against downside risk.
Call Option Example (Speculating)
Now consider an investor who doesn't own the stock but believes it will rise in value. The stock is trading at $50 per share. The investor buys a call option with a $50 strike price, expiring in one month, for a premium of $2 per share ($200 total).
If the stock price rises to $60 before expiration, the investor can exercise the option and buy the stock at $50, then potentially sell it at $60—realizing a $10 gain per share. After subtracting the $2 premium, the net profit is $8 per share, or $800 total (excluding broker fees). This strategy allows the investor to profit from upward price movement with limited capital and risk.
Option Sellers and Premiums
While option buyers have the right to exercise the contract, option sellers (also called writers) have the obligation to fulfill the contract terms if exercised. In return, they collect a premium upfront.
If the stock price ends above the strike price at expiration, a put option becomes worthless, and the seller keeps the premium. If the stock price ends below the strike price, a call option becomes worthless, and again, the call writer retains the premium. Sellers profit when the option expires unused—but they also face significant risk if the market moves unfavorably.
What is FX?
The foreign exchange market, commonly referred to as the forex or FX market, is the global marketplace for trading one nation's currency for another. It operates entirely online, with no centralized location or single governing authority. Instead, it functions as an electronic network connecting banks, brokerages, institutional investors, and individual traders. The forex market determines the daily exchange rates for most of the world's currencies.
When a traveler exchanges U.S. dollars for euros at a bank or exchange kiosk, the number of euros received depends on the current forex rate. Forex traders, however, aim to profit from fluctuations in currency values. For example, if a trader expects the British pound to strengthen, they may exchange U.S. dollars for pounds. When the pound's value increases, the trader can reverse the transaction, converting the pounds back into more dollars than before.
In forex trading, currencies are always quoted in pairs, such as USD/CAD, EUR/USD, or USD/JPY. These pairs represent the exchange rate between two currencies — for example, USD/CAD = 1.2569 means it costs 1.2569 Canadian dollars to buy one U.S. dollar. If the rate rises to 1.3336, it now costs more CAD to buy one USD, meaning the U.S. dollar has strengthened relative to the Canadian dollar.
Forex trading typically occurs in three types of markets:spot, forward, and futures. The spot market is the most straightforward — it involves an immediate exchange of currencies at the current exchange rate, known as the spot rate. Most spot transactions settle within two business days. Short-term price movements in the forex market are often driven by technical trading, which focuses on price trends and momentum. Longer-term movements, however, are influenced by fundamental economic factors such as interest rates, inflation, and economic growth.
A forward trade refers to an agreement to exchange currencies at a specified date in the future, beyond the standard spot settlement period. The forward rate is based on the current spot rate, adjusted for the interest rate differential between the two currencies. This allows participants to hedge against potential future currency fluctuations.
Forex futures are standardized contracts traded on regulated exchanges, unlike spot or forward contracts which are typically over-the-counter (OTC). In a forex futures contract, a buyer and a seller agree to exchange a specific currency amount at a fixed rate on a future date. Companies engaged in international business often use such contracts to protect themselves from adverse currency movements, while traders may use them for speculative purposes.