Given the current market turmoil where correlations across asset classes have dramatically come together, multi-asset investors should explore every tool in the box, and derivatives have a key role to play.
They are most often used to hedge against future price movements and as a way of limiting the risks of price swings in the underlying assets on which they are based.
The first concrete record of a derivative contract dates to about 600BC, when Greek philosopher Thales of Miletus used his knowledge of astronomy to predict a bumper olive crop and hired all the olive presses, so that when the harvest was ready, he would be able to let them out at a rate that brought him sizeable profit.
His prediction turned out to be correct, and the world’s first derivative trader became very rich.
From this very early start, the derivatives market has grown to be incredibly extensive.
Derivatives are traded privately (over-the-counter, or OTC) or via an exchange.
The OTC market is larger, and unregulated.
As such, OTC derivatives generally have greater counterparty risk.
The advantage, though, is the ability to tailor contracts to very specific needs – it is like being measured for a bespoke suit, but with a weakened right of return if it splits at the seams.
On the other hand, exchange-traded derivatives are off-the-peg but come with more protections.
In 2021, the total notional amount outstanding for OTC contracts in the derivatives market was about $600tn ($491tn), with exchange-traded volumes running up to about $10tn daily turnover in early 2022.
By contrast, the global bond market is estimated to be about $130tn, and the value of stock markets globally slightly less.
Derivatives have myriad different structures and uses, but break down into a handful of fundamental types.
Forward and futures contracts
Forward contracts are the oldest and simplest.
These are OTC contracts to buy and sell an asset at a set price on a specific future date.
Futures are very similar but are traded on a recognised exchange.
In this case, the buyer and seller do not enter into a direct agreement but have an agreement with the exchange providing enhanced security.
Unlike futures and forwards, options contracts are asymmetrical in relation to counterparty duties and obligations.
Where futures and forwards require both parties to make a transaction at a specified price on a given date, options require one side to do this, while the other has a choice in determining whether the trade takes place with the party; paying more for this privilege.
There are basically two types of option: one where the buyer has the right but not the obligation to transact (or a call option), and the other where the seller has the right (a put option).