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Derivatives are financial instruments whose value depends on the value of another asset, known as the underlying asset. As described by InfoMoney, derivatives are financial instruments with a price “derived” from the price of an asset, a reference rate, or even a market index. They are used to help manage financial risk, gain leverage, or speculate on changes in the price of the underlying asset.
To better understand these purposes, let us examine the types and definitions outlined below:
- Hedging: Derivatives are used to minimize financial risk by purchasing a derivative that complements an already owned asset. This is often done by pension funds, for instance. An example is sugarcane futures contracts, which sugarcane farmers purchase to protect against future price fluctuations and secure a stable selling price.
- Leveraging: Derivatives are used for the purpose of increasing exposure to an asset whilst using a relatively little capital. A common example is a Contract for Difference (CFD), an agreement between two investors that involves only the financial settlement of a security, not its delivery. However, it is important to note that leverage also increases the risk of loss, as adverse price changes in the underlying asset can lead to significant losses.
- Speculation: Derivatives are used to invest in an asset with the expectation of profiting from future price fluctuations.
In Brazil, the 4 most common types of derivatives are:
- Forward Contracts
- Futures Contracts
- Options
- Swaps
Forward contracts
A forward contract obligates the investor to buy a specific quantity of a commodity or financial asset at a predetermined price, which is established at the time of the agreement, for settlement on a future date also set at that moment. Conversely, for those selling a forward contract, the commitment is to sell the same commodity or asset.
Forward contracts can be traded on the stock exchange or over-the-counter (OTC) market, which is a trading system that operates outside traditional stock exchanges. In this environment, transactions are allowed to occur directly between buyers and sellers without a public intermediary, such as a stock exchange.
Futures Contracts
A futures contract, like a forward contract, obligates the investor to buy an asset at a set price on a given future date. The key difference lies in settlement: futures contracts are adjusted daily based on the reference price of the asset, whereas forward contracts settle only on the pre-established maturity date.
As such, operations are adjusted daily according to market expectations for the future price of the reference asset, considering the average price of transactions of said asset in the futures market. This creates a system in which gains and losses are calculated on a daily basis. The difference between daily settlement prices is calculated from one trading day to the next. If the difference is negative, the investor must pay it; if positive, the investor receives the amount in their account.
Unlike forward contracts, futures contracts can only be traded on stock exchanges.
Options
Options are the right to buy or sell an asset at a fixed price, known as the premium, on a future date. The seller of the option is called the bidder, and the buyer is called the holder. It should be noted that the premium is not the price of the asset itself, but the amount paid with the intent to later buy or sell the asset.
The holder of the option can choose to let it expire without any major consequences, other than losing the premium paid. On the other hand, the bidder is obligated to fulfill the option if the holder decides to exercise it. Thus, for example, if a holder wants to buy shares of a company at the price specified in the option, the bidder must sell those shares at the pre-agreed price.
In Brazil, options are commonly used for buying or selling shares, and transactions are conducted with full transparency, whether on the stock exchange or the OTC market. Options can be standardized, listed on trading floors with expiration dates set by the stock exchange, or non-standardized, traded on the OTC market with contractual terms defined between holders and bidders.
Binary, digital, or fixed-return options should not be confused with stock options. These are negotiated directly between buyers and sellers through brokerage firms and are not regulated in Brazil. They offer returns based on whether the investor correctly predicts the negative or positive short-term movement of an asset (currency, index, share, or commodity). This can happen in a matter of minutes.
Swaps
Swaps are agreements to exchange the profitability between two assets, with both investors aiming to reduce their risks. In practice, Investor A exchanges the profitability of Asset A for the profitability of Asset B, owned by Investor B. If the profitability of Asset B is higher than that of Asset A, Investor A will receive the greater difference between product B over product A. Conversely, if Asset B’s profitability is lower than Asset A’s, Investor B will receive the greater difference between product A over product B.
Swap agreements are categorized into the following types:
- Index Swap: In an index swap agreement, the parties exchange cash flows based on the return of a price index, such as IPCA, IGP-M, or stock indexes like Ibovespa and IBrX-50.
- Interest Rate Swap: In an interest rate swap agreement, the parties exchange the variation of a specific interest rate. One party assumes the results of a pre-fixed rate, while the other assumes the results of the same rate with exposure to post-fixed variation.
- Currency Swap: In a currency swap agreement, the rates or profitability of financial assets are exchanged between economic agents. This is particularly useful for protecting against excessive fluctuations of the US dollar relative to the Brazilian real.
- Commodity Swap: In a commodity swap agreement, two institutions exchange cash flows based on the price variations of commodities such as oil, soybeans, or corn the like.
Conclusion
As outlined, the derivatives market is considered high-risk and can lead to significant gains or losses. Therefore, investors should approach this market with caution, seeking guidance from a reliable broker and competent legal advice to ensure their rights are protected and to understand their responsibilities when trading these instruments.
