Glossary - All about derivatives
In an economic context marked by high volatility and increasing uncertainties, derivatives prove essential to support financial decisions and secure the commitments of companies and investors.
Definition of a derivative product
A derivative product is a financial instrument whose value depends on the performance of an underlying asset (stocks, bonds, commodities, currencies, interest rates, or indices). These contracts set today the terms for an exchange of future cash flows.
Origin and Objectives of Derivative Products
Historically, derivative products were created to meet a fundamental need: protection against price fluctuations. They were primarily used as hedging instruments, allowing companies and investors to secure their transactions against market uncertainty.
For example, an exporter could use a forward contract to protect against exchange rate variations.
Over time, their role has significantly expanded. Today, derivatives are no longer limited to risk management.
They have become strategic instruments that optimize financial performance through sophisticated strategies, take speculative positions to anticipate market movements, and seize opportunities.
They also serve to arbitrage price differences between different markets or financial instruments to generate profits.
These developments have made derivatives an essential tool for savvy investors, capable of combining hedging, speculation, and arbitrage within a unified management approach.
Types of Derivative Products
Derivative products come in several categories, each designed to meet specific needs for hedging, speculation, or arbitrage in financial markets.
| Category | Derivative Product | Description |
|---|---|---|
| Firm Product | Over-the-Counter Forward Contracts (Forwards) | Bilateral agreement to buy/sell an asset at a fixed price and date |
| Standardized Future Contracts | Standardized contracts traded on exchanges with fixed characteristics | |
| Swaps | Exchange of financial flows (interest rates, currencies, commodities) | |
| Optional Product | Options | Right to buy or sell an asset at a fixed price, without obligation |
| Warrants | Securities granting the right to buy or sell an asset | |
| Turbos | Leveraged instruments with a knockout barrier |
| Underlying Asset | Description |
|---|---|
| Stocks and Bonds | Financial securities representing ownership (stocks) or debt (bonds), e.g., shares, bonds |
| Stock Market Indices | Indicators grouping several stocks to measure market performance, e.g., CAC 40, S&P 500 |
| Commodities | Natural resources used for hedging or speculation, e.g., oil, gold, wheat |
| Currencies and Exchange Rates | Currencies traded on foreign exchange markets (Forex), sensitive to economic fluctuations, e.g., EUR/USD, USD/JPY |
| Interest Rates and Credit Events | Financial parameters influencing the cost of money and credit risk, e.g., LIBOR rates, CDS (Credit Default Swap) |
Use of Derivative Products
Derivative products, initially designed for risk hedging, are now used for three main purposes:
| Purpose of use | Description | Exemple concret |
| Hedging | Protection against price fluctuations and reduction of exposure to market risk. | An exporter uses a forward contract to hedge against exchange rate risk. |
| Spéculation | Anticipation of market movements to make profits, often using leverage which amplifies gains but also losses. | An investor bets on the rise of an index through a call option. |
| Arbitrage | Exploitation of price differences between different markets or financial instruments to generate a theoretically risk-free profit. | Taking advantage of a price difference between two stock exchanges. |
How a derivative product works
Structure of a derivative contract
Stakeholders : The functioning of a derivative product is based on a contract between two parties: a buyer and a seller
- Terms: This contract defines specific conditions such as the price, quantity, and maturity. The objective is to set in advance the terms of a future transaction in order to reduce uncertainty related to market fluctuations.
- Concrete example: A forward contract on a commodity fixes today the purchase price for a future delivery, thereby reducing the risk related to price volatility. A company wishing to secure its purchase price can enter into this type of contract with a supplier. Thus, it commits to buying the commodity at a price fixed today, but for delivery at a later date. This mechanism protects the company against a possible increase in market prices.
Advantages and Disadvantages
| Advantages of derivative products | Disadvantages of derivative product |
| Effective management of financial risks | Complexity requiring a good understanding of the mechanisms |
| Access to specific and diversified markets | Risk of significant losses, sometimes exceeding the initial investment |
| Optimization of financial performance | High exposure to market volatility |
Derivative Markets
- Organized markets: e.g., Euronext, CME Group, with standardized contracts and a clearinghouse.
- Over-the-counter (OTC) markets: bilateral, customized transactions but less transparent.
Regulations and Supervision
Derivative products are regulated to ensure transparency and financial stability. In France, the AMF (Autorité des marchés financiers) plays a key role.
Specific Use Cases
- Credit derivatives: e.g., CDS (Credit Default Swaps), used to protect against default risk.
- Climate derivatives: contracts linked to weather events, useful for companies exposed to weather-related risks.
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