Introduction to Derivatives

Financial derivatives are contracts whose value depends on an underlying asset, rate, or index.
They are the building blocks of modern financial markets, used for risk management, speculation, and price discovery.

What Are Derivatives?

A derivative does not represent ownership of an asset itself — instead, it defines a contractual relationship based on the performance of another variable such as:

• Stock price (e.g., options on Apple shares)
• Interest rate (e.g., swaps, caps, floors)
• Currency exchange rate (e.g., FX forwards)
• Commodity price (e.g., oil, gold futures)
• Market index or volatility (e.g., S&P 500 options, VIX futures)

In short, derivatives are financial engineering tools that allow exposure to an asset without directly holding it.

Why Are Derivatives Important?

1. Risk Management (Hedging)
   Derivatives allow companies and investors to protect themselves from adverse price movements.
   • An airline can hedge against rising jet-fuel prices using oil futures.
   • An exporter can lock in exchange rates using FX forwards.
   • A bondholder can hedge interest-rate risk with swaps or options on Treasury futures.
2. Speculation and Leverage
   Traders can take leveraged positions to express directional or volatility views.
   • Buying a call option provides upside exposure with limited downside.
   • Shorting volatility through options strategies can generate yield in stable markets.

3. Arbitrage and Market Efficiency
   Professional traders exploit pricing differences between related instruments — ensuring no-arbitrage relationships such as put–call parity and cash-and-carry consistency.

4. Customization and Financial Innovation
   Derivatives can be structured to replicate complex payoffs, support structured products, or manage portfolio risk precisely.

Real-World Scale and Participants

The global derivatives market is vast — with notional outstanding in the hundreds of trillions of USD, spanning both exchange-traded and over-the-counter (OTC) products.

Segment	Typical Instruments	Where Traded
Exchange-Traded	Futures, options	CME, ICE, Eurex, HKEX
OTC Markets	Swaps, forwards, exotic options	Interbank / bilateral
Clearinghouses	CCPs manage counterparty risk	LCH, CME Clearing

Key participants include:

• Corporates: hedge revenues and costs
• Institutional investors: manage portfolio risk and duration
• Banks: provide liquidity, market-making, and structuring
• Hedge funds / prop traders: exploit inefficiencies
• Regulators and clearinghouses: ensure transparency and systemic stability

When and Why Derivatives Matter

The use and pricing of derivatives depend heavily on market conditions:

Market Environment	Typical Derivative Use	Example
Rising volatility	Buy protective puts, trade VIX futures	Portfolio insurance
Falling rates	Pay fixed in interest-rate swaps	Duration management
Strong dollar	Hedge foreign revenue via FX forwards	Exporter risk hedge
Commodity shocks	Lock input costs with futures	Airline fuel hedging
Calm equity markets	Sell options to earn premium	Volatility harvesting

Derivatives are thus state-contingent instruments — their appeal and payoff depend on expectations of future market behavior.

Example: Using Futures to Hedge Price Risk

Suppose an airline expects to buy 1 million barrels of jet fuel in three months.
Current price is $85/barrel, but management fears an increase.
By buying oil futures at $86/barrel on the CME, the airline locks in its future cost:

• If spot rises to $95 → futures gain offsets higher cost.
• If spot falls to $80 → hedge loses, but fuel is cheaper.

This simple transaction stabilizes budgeting and removes price uncertainty — demonstrating the practical role of derivatives.

Key Takeaways

• Derivatives transfer risk rather than eliminate it.
• Their value derives from the behavior of underlying assets.
• They link cash and futures markets, anchoring prices via arbitrage.
• Understanding derivatives is essential for risk management, trading, and quantitative modeling.

Next up: Forwards & Futures