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At their simplest, derivatives are financial contracts between two parties.

A contract’s value is driven by the value of its underlying assets, which can be equities or equity indexes, currencies, commodities and interest rates. Some derivatives are even tied to credit events (i.e., bankruptcy or failure to pay debt), which have the potential to affect the cash flows of financial instruments, like bonds.

That description may make derivatives contracts sound like ETFs, but they’re more complex. They lock investors into financial arrangements because futures and forward contracts include agreements to buy or deliver assets at specific dates, while swaps contracts lock people into strict payment schedules.

And, unlike normal margin accounts, using derivatives can give people or firms a lot of leverage, says Christopher Foster, co-founder and owner of Blackheath Fund Management.

That’s why “bank-owned brokerage firms don’t like the idea of investors getting first-hand exposure to derivatives,” he adds. Aside from their association with events like the Great Recession, derivatives require “advisors to be more attentive when using and monitoring them. Investing in derivatives isn’t like buying a stock and parking it for 10 years.”

Still, “investors have lots of second-hand exposure to derivatives since a lot of mutual funds and ETFs trade in derivatives, and the structured products they buy from their brokers have a lot of derivatives embedded in them.”

But, very few in the Canadian broker-dealer world have enough experience to guide investors, says Foster. When he was a product specialist at ScotiaMcLeod, he found “the traditional advisor didn’t have appropriate licensing or experience.”

So, “there’s actually a bit of a gap in the market,” which is why many wealthy Canadians who use derivatives end up “dealing with U.S. or other foreign brokers who handle these kinds of exposures.”

This doesn’t have to be the case. Here’s how to better answer client questions about these complicated instruments.

Common derivatives products

There are several types of derivatives contracts. Though each is structured differently, the values of each is derived from the values of underlying assets, such as equities, equity indexes, or even currencies and commodities.

Traders use derivatives to hedge portfolio risk, as well as to speculate on sectors or markets. Common product types include the following:

Forward contracts. These are agreements to buy or sell certain asset amounts at specific prices. They include specified dates of delivery. The contracts are customized to meet the needs of both counterparties. The transactions are primarily settled over-the-counter.

Futures contracts. These are also agreements to buy or sell certain asset amounts at specific prices, and they, too, include specific delivery dates. However, futures contracts are standardized, and are also regulated and settled through clearing houses. Investors trading futures can realize gains or losses daily prior to the delivery date.

Swaps. These are agreements between two parties that stipulate each will take part in a series of cash payments for a certain period of time. Those payments can be based on fixed or floating interest rates, and they’re calculated based on the agreed-upon notional principal amount. Interest-rate swaps are common, says BLG derivatives expert Carol Derk. They’re often used “when a company’s just entered into a new loan arrangement with a bank and they’ve agreed to pay a floating rate of interest. If they want to have certainty as to what they’re going to have to pay for that notional amount over a period of time, a swap helps them manage their business better.”

That’s because the company can enter into an interest-rate swap with another financial institution, whereby that institution agrees to pay the floating rate of interest that the company owes to the bank. In return, the company agrees to pay the second financial institution a fixed rate of interest, either over a short period, such as a few months, or over a longer period.

Options contracts. There are two types: call option contracts, which give investors the right to buy specified amounts of assets at certain exercise prices on or before future dates; and put options, which allow purchasers to sell specified amounts of assets at exercise prices on or before future dates.

A trader would use a call option if he expects a stock’s price to rise, and he’d use a put option if he expects the price to fall. He has to pay a premium for the right to trade stock at prices above or below market value, but he then has the option to benefit from stock-price volatility without actually owning or borrowing stock. If he doesn’t exercise his options, he only loses the premium.

– Source: Article sources; “Derivatives, markets, products and participants: An overview,” a 2012 paper by Japan-based senior business consultant Michael Chui

Derivatives basics

Forwards, options and swaps are over-the-counter, while futures and options on futures are typically exchange-traded, says Carol Derk, leader of the derivatives focus group at BLG.

With OTC derivatives, a client (either an individual or a company) enters into a bilateral agreement with a financial institution to set out the terms of the forward option or swap. These derivatives are typically used by large-scale investors, such as institutional ones.

Derk says the most common type of OTC derivative is the interest-rate swap. There are also currency swaps (companies hedge against currency volatility if they owe payments in foreign currencies) and credit default swaps (bond buyers seek protection against the loss of principal payments should bond issuers default).

Meanwhile, exchange-traded futures and options on futures are traded on the Montreal exchange, as well as ICE Futures Canada, located in Winnipeg. Both types of derivatives allow investors to buy or sell specific quantities of assets for fixed prices on agreed-upon dates (see “Common derivatives products,” this page).

Right now, most investors who are getting into derivatives are doing so for hedging purposes. But, Derk says, other investors use derivatives for speculative purposes, “either because they can’t get exposure to some markets other than through a specific type of investment—take Canadians who can’t buy stocks in India due to India’s legislation—or because people want to leverage up by investing more money than they currently have to enhance returns.”

Taking a closer look

Farmers have been using derivatives for hundreds of years to help hedge against commodity-price volatility, notes Greg Jones, managing director of global equity derivatives at National Bank. Investors may have a negative impression about derivatives, but there is a growing and regulated market. Today, farmers continue to use derivatives to manage production and obtain predictable prices. This example can help us understand how derivatives stabilize markets and promote liquidity.

During harvest time, says Foster, farmers get ready to sell their products. They’ll need that revenue to pay down mortgages or buy new farm equipment, seed and supplies. Take wheat farmers, who have a limited window for selling their crops. While they can choose to store products after harvest time, they may not have enough money or space to do so, especially if crops were substantial. Also, many farmers need funds immediately to cover harvest costs.

So, “they all tend to sell their wheat in October, November and December,” says Foster. “And that creates substantial price weakness.”

However, derivatives traders and speculators understand these seasonal weakness cycles; they also know prices will bounce back. So they buy the wheat through futures or forward agreements and hold until there’s more demand. In those contracts, they strike sale agreements for future dates at specified quantities and prices.

Thanks to those derivatives agreements, farmers don’t have to sell at lower prices, and markets are more efficient. “There’s lots of nefarious things that speculators can potentially get up to,” Foster adds, “but, in terms of the operation of the materials market, derivatives traders provide a moderating influence to price swings for the benefit of consumers and producers.”

Derivatives can also help commodities producers hedge. By minimizing risk for farmers, or producers of other commodities, derivatives traders allow production increases at times when low output would otherwise create demand gaps.

That said, farmers entering into derivatives agreements must do their due diligence, since they can’t get out of forward agreements. They can only counter forward agreements by entering into second, contrasting agreements with the same party they entered into the initial agreement with.

In contrast, it’s possible to cancel out futures agreements that are traded on exchanges by entering into counter agreements that list the same prices, dates and terms. To do this, a trader can go short or long in stocks or commodities that he’s currently long or short in, respectively.

Get licensed

The Canadian Securities Institute offers a series of courses for registered representatives who want to get futures or options licences, and for those who want to become Derivatives Market Specialists.

An advisor who wants to be registered as a commodity trading advisor, commodity counsel or commodity trading manager can do so if:

  • she’s a registered representative;
  • an IIROC firm employs her; and
  • she completes both the Derivatives Fundamentals Course and the Futures Licensing Course.

In Ontario, she must abide by the Commodity Futures Act, and by the Commodity Futures Trading Commission when handling U.S. futures.

To date, there’s a lot of overlap between the categories of registered firms that are able to trade derivatives or provide advice, say securities regulators. As well, some market participants can trade or advise in relation to derivatives without being registered if they aren’t considered in the business of doing so regularly. As such, it’s hard to track how many firms are active in the derivatives market. What’s more, firms are often registered in different capacities in more than one province or territory.

Source: Canadian Securities Institute; securities regulators.

Who’s in the market?

Though some wealthy individual investors use derivatives, the market is mostly made up of large-scale traders, such as fund companies, and those who are trading on behalf of companies tied to assets like commodities.

For example, fund providers investing in materials markets may use derivatives since it’s expensive to store certain physical commodities, such as wheat and copper. Storage also removes those commodities from trading markets.

However, with “easily storable commodities such as silver and gold, it only costs a fraction of a percent per year to store them,” says Foster. “So companies can actually set up a fund that owns the commodities. In that case, investors are actually buying a percentage of the trust that owns the physical commodities.”

So through derivatives, such as futures contracts, funds can get and provide exposure to these materials. Still, says Foster, derivatives can also “exacerbate market risk, depending on the how they’re structured, traded and sized.

Using derivatives can be more risky if people or firms take more leverage” than they
can handle. “If they bought $10,000 worth of wheat and put it in a warehouse, the most they could lose is the $10,000 initially invested,” says Foster. “But in the derivatives space, they can use leverage to buy or sell more wheat” than they’d normally be able to, and could lose much more.

But larger investment companies can afford compliance and risk management departments that “impose trading limits to make sure market risks don’t impact unit holders,” he explains. “They’re able to stipulate that traders can only have positions of certain sizes”
and only handle trades up to specific sizes.

When it comes to individual advisors who trade in derivatives, he notes, “technology’s already made monitoring easier since managers are now informed in real-time when traders or accounts reach risk limits.”

Action Step
Explain how a derivative’s value is driven by the worth of its underlying assets.

Originally published in Advisor's Edge Report

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