Derivatives and Risk

The definition of a derivative, drawn from the ACT glossary, is “a derivative instrument (or contract) is one whose value and other characteristics are derived from those of another asset or instrument.” This ‘other asset or instrument’ is normally a conventional asset such as a barrel of oil or an ordinary share. The price of the derivative is determined by (or derived from) the price of the underlying asset, hence the term.

The term tends to be used to refer to the newer financial instruments although most of the financial instruments that we think of tend to fall into the strict definition of a derivative. So foreign exchange forward, as an example, would be a derivative as well as the structured option products that sound more exotic.

There are two broad groups of derivative instruments: fixing instruments and option instruments. The groups are fairly self explanatory: the fixing instruments allow the user to exchange an unknown future value (say for an exchange rate or interest rate) for a known future value. This is sometimes described as removing risk in that uncertainty is replaced by certainty. Unfortunately that is not the whole story.

The other group of instruments is categorised by optionality: the ability to walk away from the ‘contract’ if you prefer to do so – in other words if it is not to your advantage; you have the right but not the obligation.