What Is a Derivative?

When you decide how to limit losses from moves in exchange rates or interest rates, or explain the profit or loss of a product to a customer, you use the way an underlying asset's value determines profit or loss. Knowing it lets you explain why a given trade gains or loses.

A trade whose profit or loss depends on the value of an underlying asset

A derivative is a trade whose profit or loss depends on the value of another asset or indicator. The asset or indicator it is based on is called the underlying asset¹. The English word "derivative" means "derived from something else," and in Japanese derivatives are also called kinyu haisei shohin (financial derivative products) or haisei shohin (derivative products)¹.

Suppose, for example, that Company A agrees with Company B to buy dollars in 3 months at an exchange rate fixed today. A trade like this, in which the price and quantity are agreed now and the purchase or sale takes place on the agreed date, has the form of a forward contract²³.

Today the two only agree on the terms; no dollars or yen change hands. In 3 months, the seller, Company B, delivers dollars to the buyer, Company A, and Company A pays Company B the yen calculated at the rate agreed today. Whatever the market rate is in 3 months, the amounts exchanged are those agreed today.

If, in 3 months, the dollar costs more in the market than the agreed rate, Company A gains because it buys dollars more cheaply than in the market, and Company B loses. If the dollar is cheaper than the agreed rate, Company A pays more than the market price, and the gain and loss switch sides². The direction of the price move after the agreement decides which side gains and which side loses, and Company A's gain is exactly Company B's loss.

What can be an underlying asset

Underlying assets include not only the prices of financial instruments such as stocks, bonds, and foreign currencies, but also indicators such as the level of interest rates. There are also weather derivatives linked to temperature or rainfall¹. The table shows typical underlying assets and examples of trades that use them⁴.

Three basic forms and how their profit or loss differs

The three basic forms of derivatives are forwards and futures contracts (together counted as one form), swaps, and options. Some products combine futures with options, or swaps with options⁶. The three forms differ in what the parties promise, and so the way profit or loss responds to price moves also differs.

In forwards and futures, when the agreed date comes, the parties buy and sell at the agreed price whatever the price is at that time². So whether the price rises or falls, each side gains or loses by the amount of the move. How the two differ is covered on the Forwards and Futures page, with numerical examples and charts of the profit or loss at maturity.

The typical swap is an interest rate swap, which exchanges a fixed rate and a floating rate in the same currency. Suppose a company that borrows at a floating rate enters into a swap in which it pays a fixed rate and receives a floating rate. If rates rise, the payments it receives on the swap cover the increase in interest on its loan. If rates fall, on the other hand, the swap on its own shows a loss because the payments received go down. That loss offsets the fall in interest on the loan, so the company does not benefit from the lower rates⁷.

An option is a trade in a right to choose whether to buy or sell a financial instrument at a price set in advance (the strike price). To buy the right, the buyer pays a fee (the option premium)⁸. The buyer exercises the right only when doing so is profitable, so its loss is limited to the premium paid. The seller receives the premium and in return takes on the obligation to perform if the buyer exercises. Its loss can therefore far exceed the premium received⁹. For the seller of a right to buy (a call), the loss grows as the price of the underlying rises, with no upper limit.

Notional amounts and leverage

In derivatives, the amount used to calculate profit or loss is very different from the money that actually changes hands when the trade starts. An interest rate swap sets a principal amount for calculating interest, but that principal itself is never paid or received. This principal used only for calculation is called the notional amount⁷. Consider a fictional interest rate swap with a notional amount of 10 billion yen. If the floating rate rises by 0.5 percentage points, the side receiving the floating rate receives 10 billion yen × 0.5%, or 50 million yen, more for one year. If rates fall by the same amount, it receives 50 million yen less.

Futures can be traded by depositing margin at the start of the trade, without having to prepare the full price as you would when buying or selling the underlying asset¹⁰. The ability to make large trades with little money is called the leverage effect. According to the Japan Exchange Group glossary, the trading value of futures is tens of times the margin. So a large profit is possible, but if the forecast is wrong, the loss is large too¹¹.

Consider a fictional purchase of futures on 100 million yen of the underlying asset, made by depositing 5 million yen of margin. If the price of the underlying rises 5%, the profit is 5 million yen, equal to the margin deposited. If it falls 5%, the loss is 5 million yen, and if it falls 10%, the loss is 10 million yen, more than the margin deposited.

Three categories under the Financial Instruments and Exchange Act

The Financial Instruments and Exchange Act divides derivatives transactions into the following three categories¹².

• Market derivatives transactions: trades on an exchange market
• Over-the-counter derivatives transactions: trades that do not go through an exchange market
• Foreign market derivatives transactions: trades on a foreign market

The differences between exchange-traded derivatives, bought and sold on an exchange, and OTC derivatives, agreed between the parties, are covered on the Exchange-Traded vs OTC Derivatives page.

Purposes and main risks

The main uses of derivatives are hedging and speculation. Hedging uses derivatives to limit losses from price moves in assets you hold or plan to buy or sell. Speculation means trading on an expected rise or fall to profit from price moves. Because derivatives can be traded with little money, they are also widely used for speculation¹⁰.

Investment approaches using futures include arbitrage, besides speculation and hedging. Arbitrage is trading that uses price differences for the same product, or products of the same kind, between different markets³.

The main risks in using derivatives are the following three.

• Market risk: the risk of losses from changes in the price of the underlying, interest rates, or exchange rates¹⁰.
• Counterparty credit risk: in trades settled directly between the parties, if the counterparty fails, you may not receive money you were due. You take on this risk with every counterparty you trade with¹³. In trades in which a central counterparty stands between the parties, you can trade without being concerned about the credit risk of each counterparty¹³.
• Limits on early termination: as an example of what financial institutions explain to customers, the Financial Services Agency states that derivative products cannot, as a rule, be terminated. If customers terminate early for their own reasons, an early termination payment may be required¹⁴. Exchange-traded futures, by contrast, can be closed out by the last trading day with an offsetting trade: selling futures you bought, or buying back futures you sold¹⁵. The contract terms are standardized so that offsetting trades are possible³.

Notes

1. Central Council for Financial Services Information, "1-1 デリバティブとは？（やさしいデリバティブ）" (What is a derivative?, Easy Derivatives, in Japanese), the main text and "デリバティブの対象" (What derivatives are based on). ↩ ↩² ↩³

2. Central Council for Financial Services Information, "2-1 先物取引とは？（やさしいデリバティブ）" (What is futures trading?, Easy Derivatives, in Japanese), the opening and "パターン（1）" (Pattern 1) and "パターン（2）" (Pattern 2) in the example of reserving a ring. ↩ ↩² ↩³

3. Pension Fund Association, "先物取引（用語集）" (Glossary: futures trading, in Japanese), the main text. Forward contracts and offsetting trades are in the first paragraph ("反対売買が可能なように標準化されたもの", standardized so that offsetting trades are possible; our translation), and the investment approaches are in the third paragraph. ↩ ↩² ↩³

4. The interest rate, exchange rate, equity, and commodity rows are from the table in Central Council for Financial Services Information, "1-4 デリバティブの種類（やさしいデリバティブ）" (Types of derivatives, Easy Derivatives, in Japanese). The weather row is from "デリバティブの対象" (What derivatives are based on) in "1-1 デリバティブとは？" (What is a derivative?) in the same course. The bond row is from Japan Exchange Group, "商品概要（国債（JGB）先物）" (Product overview: JGB futures, in Japanese), "商品概要" (Product overview) and "関連情報" (Related information). ↩

5. "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation), Article 2, paragraph 21, item 5. A company's credit standing is sub-item (a) of that item (events related to the credit standing of a juridical person, and other similar events specified by Cabinet Order). ↩

6. Central Council for Financial Services Information, "1-4 デリバティブの種類（やさしいデリバティブ）" (Types of derivatives, Easy Derivatives, in Japanese), the first sentence and the paragraph after the table. ↩

7. Central Council for Financial Services Information, "4-2 金利スワップの仕組み（やさしいデリバティブ）" (How interest rate swaps work, Easy Derivatives, in Japanese), the example of borrowing at a floating rate and the paragraph on "想定元本" (Notional amount). ↩ ↩²

8. Central Council for Financial Services Information, "3-1 オプション取引とは？（やさしいデリバティブ）" (What is option trading?, Easy Derivatives, in Japanese), "デリバティブのオプションは？" (What is an option in derivatives?). ↩

9. Central Council for Financial Services Information, "3-4 オプション取引の損益（やさしいデリバティブ）" (Profit and loss from option trading, Easy Derivatives, in Japanese), "オプション取引の買い手の立場" (The position of the option buyer) and "オプション取引の売り手の立場" (The position of the option seller). ↩

10. Central Council for Financial Services Information, "1-3 デリバティブの特徴と利用法（やさしいデリバティブ）" (Features and uses of derivatives, Easy Derivatives, in Japanese), "利便性" (Convenience), "ヘッジング（hedging）" (Hedging), "スペキュレーション（speculation）" (Speculation), and "マーケット・リスクの例" (Examples of market risk). ↩ ↩² ↩³

11. Japan Exchange Group, "先物取引（用語集）" (Glossary: futures trading, in Japanese). ↩

12. "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation), Article 2, paragraph 20 (derivatives transactions), the opening part of paragraph 21 (market derivatives transactions), the opening part of paragraph 22 (over-the-counter derivatives transactions), and paragraph 23 (foreign market derivatives transactions). ↩

13. Japan Securities Clearing Corporation, "金利スワップ 債務負担" (Interest rate swaps: assumption of obligations, in Japanese), "債務負担の具体例" (Examples of assumption of obligations). An English version is available: "IRS Clearing", "Example of Clearing". ↩ ↩²

14. Financial Services Agency, "デリバティブ商品を契約するときのポイント" (Points to check when entering into a derivative product, in Japanese), "説明事項（主な例）" (Items to be explained: main examples) on the front side (page 1 of the PDF). ↩

15. Osaka Exchange, "決済方法（先物）" (Settlement methods (futures)), Kitahama Investment School (in Japanese), "反対売買による決済" (Settlement by offsetting trades). ↩