7.1 Derivatives: Role, Underlying Assets & Users
Key Takeaways
A derivative's value depends on an underlying asset such as a stock, index, bond, interest rate, currency or commodity.
Exchange-traded derivatives are standardized and centrally cleared; over-the-counter derivatives are customized and carry counterparty risk unless cleared.
Hedgers use derivatives to reduce risk, speculators to profit from expected price moves, and arbitrageurs to exploit price differences.
Derivatives provide leverage, which magnifies both gains and losses.
In Canada, listed derivatives trade on the Montréal Exchange and clear through CDCC; many OTC derivatives must be reported to trade repositories, and some must be centrally cleared.
A derivative is a contract whose value is based on (derived from) the price of something else, called the underlying asset or underlying interest. The main types, options, forwards, futures, rights and warrants, are covered in the sections that follow. This section explains why derivatives exist and who uses them.
Types of Underlying Assets
| Category | Examples of underlying assets | Example derivatives |
|---|---|---|
| Equities | Individual shares, ETFs | Equity options, rights, warrants |
| Stock indexes | S&P/TSX 60 | Index futures (SXF) and index options |
| Interest rates and bonds | CORRA, Government of Canada bonds | CORRA futures, 10-year bond futures (CGB), interest rate swaps |
| Currencies | U.S. dollar, euro | Currency forwards, futures and options |
| Commodities | Crude oil, natural gas, gold, wheat | Commodity futures and options |
| Credit | A company's risk of default | Credit default swaps |
Exchange-Traded vs. Over-the-Counter Derivatives
| Feature | Exchange-traded | Over-the-counter (OTC) |
|---|---|---|
| Terms | Standardized by the exchange | Negotiated to suit the parties |
| Trading | On an exchange such as the Montréal Exchange | Directly between the parties, often a bank and a client |
| Counterparty risk | Removed by a clearinghouse (CDCC) | Each party depends on the other, unless the trade is centrally cleared |
| Transparency | Public prices and volumes | Private prices |
| Liquidity | Easy to close by an offsetting trade | Harder to exit before maturity |
| Examples | Listed options, futures | Forwards, swaps, many currency contracts |
The Users of Derivatives
Hedgers
Hedgers already have a risk and use derivatives to reduce it.
- A Canadian gold miner that will produce gold next year sells gold futures to lock in a price.
- An exporter expecting U.S.-dollar revenue sells U.S. dollars forward to fix the exchange rate.
- A portfolio manager worried about a short-term market drop sells S&P/TSX 60 futures or buys index puts instead of selling the stocks.
Hedging gives up some upside in exchange for protection. The miner that sold futures does not benefit if gold soars, but it is protected if gold collapses.
Speculators
Speculators take on risk in the hope of profit. Derivatives appeal to them because of leverage: a small premium or margin deposit controls a much larger position. Speculators add liquidity to derivatives markets and take the other side of hedgers' trades, but they can lose more than they expect, and in some positions (such as writing uncovered calls) more than they invest.
Arbitrageurs
Arbitrageurs look for price differences between related instruments, for example when a futures contract is priced out of line with its underlying index. They buy the cheaper instrument and sell the more expensive one, locking in a small profit. Their trading keeps derivative prices consistent with the underlying markets.
Worked Example: Hedging with Index Futures
A portfolio manager runs a $10 million portfolio of large Canadian stocks that moves closely with the S&P/TSX 60 Index. Expecting a short-term decline but not wanting to sell the stocks (which would trigger trading costs and capital gains), the manager sells S&P/TSX 60 futures with a total underlying value of about $10 million.
| Outcome | Stock portfolio | Short futures | Net |
|---|---|---|---|
| Index falls 5% | −$500,000 | +$500,000 | about $0 |
| Index rises 5% | +$500,000 | −$500,000 | about $0 |
The hedge locks in the portfolio's value for the life of the futures: the manager is protected if the market falls but gives up any gain if it rises. A hedge with index put options works differently: it costs a premium up front but keeps the upside. In practice no hedge is perfect, because the portfolio does not exactly match the index (basis risk) and the futures price reflects the cost of carry.
Why Derivatives Are Useful
- Risk management: transferring unwanted price, rate or currency risk to someone willing to bear it.
- Price discovery: futures prices reveal the market's expectations for future prices.
- Lower transaction costs: changing a portfolio's exposure with one futures trade is cheaper than trading many stocks.
- Flexibility: creating payoffs that are impossible with the underlying asset alone, such as protecting against a fall while keeping the upside.
The Risks
- Leverage risk: small moves in the underlying asset cause large gains or losses.
- Counterparty risk: in OTC contracts, the other party may default.
- Liquidity risk: some contracts are hard to close before maturity.
- Basis risk: a hedge may not move exactly with the asset being hedged.
- Complexity: investors can misunderstand how a position behaves.
How Derivatives Are Regulated in Canada
Listed derivatives trade on the Montréal Exchange and clear through the Canadian Derivatives Clearing Corporation (CDCC). After the 2008 financial crisis, Canadian regulators also brought OTC derivatives under oversight: many OTC trades must be reported to designated trade repositories, and certain standardized OTC derivatives between large market participants must be centrally cleared. Dealers must assess whether derivatives trading is suitable for each client, and individuals who trade or advise on derivatives must meet CIRO's proficiency requirements.
A Canadian wheat farmer sells wheat futures in the spring to lock in a price for the autumn harvest. How is the farmer using derivatives?
As a hedger reducing price risk on an existing exposure
As a market maker providing liquidity
As a speculator seeking leveraged profit
As an arbitrageur exploiting a price difference
Which feature distinguishes over-the-counter derivatives from exchange-traded derivatives?
OTC derivatives can be closed out only on the Montréal Exchange
OTC derivatives never involve currencies or interest rates as underlyings
OTC derivatives are privately negotiated and carry counterparty risk
OTC derivatives are standardized and guaranteed by CDCC
Why do speculators often prefer options or futures to buying the underlying asset directly?
Derivatives are exempt from all margin and suitability requirements in Canada
Derivatives cannot lose value
Derivatives always guarantee a profit if held to expiry
Derivatives offer leverage on a small premium or margin deposit
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