Derivatives: Meaning, how it works, pros and cons

The world of corporate finance is filled with varying techniques that aid business concerns for growth. Various techniques are applied by industry players to ensure revenue is derived. The general aim of business is to provide products or services to the general public while maintaining profits through cost reduction.

One such productive concept for businesses is derivatives. This article offers all there is to know about derivatives and how it affects the market generally. 

Meaning of derivatives

Derivatives are financial assets that derive their value from other underlying assets. A derivative is a contract that is allowed to trade varying assets to reduce the expected risk. 

Parties get into a derivative contract with speculations that suit their position. The risks are therefore reduced and parties can both engage in business with the hopes of maintaining the status quo whether or not a shift has been made as to the underlying assets. The most common underlying assets in a derivative include currencies, stocks, bonds, interest rates, commodities and others. 

How derivatives works

Derivatives are used by investors and tradings to access markets or basically to break speculations and reduce risks. The concept offers confidence, trust and relaxation over a fixed position agreed on by the parties. The risks are reduced through cooperative understanding between the parties to the derivative agreement. 

For instance, if ADJ Ltd is a chocolate manufacturing company and SLX Ltd is a cocoa production company supplying cocoa to ADJ Ltd for 2 Naira per ton. ADJ Ltd predicts that there would be a rise in the price of cocoa in the next year, whereas SLX Ltd predicts there would be a fall in the price of cocoa. Both parties decide to enter a contract, which would sell 2 million bags of cocoa from SLX Ltd to ADJ Ltd for an agreed price but to be supplied in a year. After a year, ADJ Ltd would pay the complete sum in the contract to SLX Ltd and SLX would have the 2 million tons of cocoa delivered. Such a contract made between ADJ Ltd and SLX Ltd is a derivative contract.

From the above example, the underlying asset is the raw material (commodities) cocoa, from which the contract derives its value. If the price of cocoa in the next year increases, this means ADJ Ltd gains from the derivative contract. On the other hand, if the prices go reduced in the next year, then SLX Ltd loses. 

Types of derivatives

Derivatives can be subdivided into four broad categories for a clearer understanding of the concept; these four categories are Forwards, futures, options and swaps.

1. Forwards

Forwards are derivative contracts offered between two or more persons with one agreeing to purchase an underlying asset at a pre-agreed price at a future date. This means the price of the asset has been fixed but the transaction including the payment would take place at a future date. The illustration above on ADJ Ltd and SLX Ltd is a typical example of how forwards work.

From the example, both parties had agreed on a price of 2 Naira per ton of cocoa to be undertaken on a future date but at the agreed price set by the parties. 

Another example of forwards occurs when Bellun hotel purchases a future contract for the supply of petroleum from DNG petroleum on October 13, 2023. The contract is to expire on December 21, 2023, and is set at an agreed price of 100 Naira per litre.

Bellun hotel undertakes this futures contract with the expectation that oil prices may rise in the future but it would require litres of petroleum to power its rooms as a hotel during the festivities. 

2. Futures

Futures has the same meaning and operation styles as forwards. Nonetheless, futures are traded on the floor of the stock exchange and are highly regulated by the securities and exchange commission, unlike forwards, which lack little or no market regulation. 

3. Options

Options are another form of derivative contract. An option is an agreement between two or more parties to sell or buy underlying assets at a pre-agreed price at a future date. Unlike the futures and forwards where the parties have no freedom of choice to buy or sell the asset and must eventually buy that asset at the agreed price at the future date; the options offer the parties the freedom to buy or sell the asset at the pre-agreed price and the predetermined date.

When the option to buy is used, such is known as a ‘call option’ and when the option to sell is used, such is known as a ‘put option’.

4. Swap

Swaps are another form of derivatives, they are contracts between two parties to exchange cash-generating assets for another. Swaps are mostly used in currency exchanges and help to reduce risks.

For instance, if DXS Ltd takes a variable interest loan of 1 million Naira at 4%, but has fears that the loan may increase in the future. DXS Ltd approaches JDC Ltd to swap the loan for a fixed interest loan of 6%, this means that if the interest rate increases to 8%, JDC Ltd would be at a loss but if it reduces to 2%, DXS Ltd would pay JDC Ltd the 6% fixed interest rate, this makes JDC Ltd keep 4% gain.

Pros and Cons of derivatives

Pros of derivatives

1. Reduces risks to the barest minimum for both parties.
2. Avoids unfavourable speculations of the parties.
3. Provides a predictable transaction for both parties.
4. Allows for greater planning for future savings.

Cons of derivatives

1. It is highly uncertain.
2. Both parties cannot profit from the scheme.

Over the years, the business world has hinged on the possibility of increased profit through techniques that aid business and entrepreneurial skills for more productivity. This article provided all there is to know about derivatives.

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