Derivative

A contract about something else

A derivative owns nothing by itself. It is a contract between two parties whose payoff is calculated from the price of an underlying: a share, a bond yield, an exchange rate, a commodity. The underlying moves, the contract's value moves with it, usually in an amplified way. Four families cover almost everything:

• [Options](/dictionary/options) give one side the right, but not the obligation, to buy or sell the underlying at a set price by a set date. The buyer pays a premium for that flexibility.
• Futures lock in a price today for a purchase or sale that happens on a future date, as standardized contracts traded on an exchange. Both sides are committed; neither can walk away.
• Forwards are the same locked-in-future-price idea as a private, custom deal between two parties, the form banks use when a business asks to fix an exchange rate for a payment arriving in six months.
• Swaps are exchanged payment streams: two parties agree to trade one series of payments for another, most commonly a fixed interest rate for a floating one. A company nervous about rising rates can swap its floating payments away without touching the loan itself.

The two faces: hedging and speculation

Derivatives exist because businesses wanted to get rid of risks they never asked for. An airline locks in fuel prices with futures so a spike cannot wreck its year. An exporter paid in US dollars locks the exchange rate with a forward so a currency swing cannot erase a profit margin. A farmer sells next fall's crop at a price fixed in the spring. In each case, the derivative transfers a risk from someone who cannot afford it to someone willing to carry it for a price. The retail version of this is the currency-hedged ETF, which uses forwards to strip the currency risk out of foreign holdings.

The same contracts serve the opposite purpose just as well. Because derivatives let you control a large exposure with a small outlay, they are the natural instrument for leveraged bets on direction: on a stock, a rate, a currency, a commodity. The contract cannot tell whether it is insurance or a wager; only the position around it can.

Where you already touch derivatives

Most Canadians hold derivatives without ever placing a derivatives trade. Any currency-hedged fund runs a rolling book of forwards. Covered-call ETFs sell options across their portfolios and pay the premiums out as distributions. A market-linked GIC, the kind that promises your deposit back plus "a share of the market's growth", is a bond stapled to an option under the hood, which is exactly how it can guarantee the principal. Even a mortgage rate hold is a small free option: the lender must honour the locked rate if rates rise, and you may simply take the better rate if they fall.

Why they get scary, and the plain rule

Three ingredients give derivatives their reputation. Leverage means small price moves produce large gains and losses. Counterparty chains mean one party's failure can cascade to others who thought they were safe, a dynamic that played a central role in the 2008 financial crisis. Complexity means layered products can hide risks that even their buyers, and occasionally their sellers, do not fully understand.

None of that makes derivatives evil; hedging with them is one of the most conservative things a business can do. The plain rule for a household is simpler: if you cannot explain the payoff, do not hold it directly. Owning a currency-hedged fund whose manager runs the forwards is sensible; holding a contract whose behaviour surprises you is not.