Derivatives: what these financial instruments are and how they work

Derivative financial instruments represent a complex and advanced category of investments whose value is based on an underlying asset, also called the “underlying asset.” This means that the value of a derivative is directly influenced by the price of another asset, which can be financial, such as equities, interest rates or indices, or real, such as commodities like gold, oil or wheat. Through these instruments, investors can carry out various financial and hedging, speculation and arbitrage strategies.

Types of derivatives: symmetrical and asymmetrical

Derivatives can be classified into two main categories: symmetrical and asymmetrical. In symmetric derivatives, both parties (buyer and seller) are obligated to complete the transaction on the maturity date of the contract. This type of instrument commits both parties to a predetermined forward transaction. Asymmetric derivatives, on the other hand, give the buyer the right to decide whether to complete the transaction at maturity. Here, only the seller has a contractual obligation, while the buyer, by paying a price called a premium, retains the freedom to exercise or not to exercise the right to buy or sell. This mechanism is particularly useful for managing exposure to possible price changes.

Regulated and over-the-counter (OTC) derivatives.

Another key distinction is between regulated and over-the-counter (OTC) derivatives . Regulated derivatives are traded in official markets and follow well-defined standards for characteristics such as duration, settlement mode and minimum quantity. In Italy, the main market for these instruments isIDEM, managed by Borsa Italiana, and instruments such as futures, options and covered warrants are traded there. In the case of OTC derivatives, on the other hand, trading takes place directly between two parties, without the intervention of a regulated market. This type of instrument offers greater contractual flexibility, allowing parties to freely define the characteristics of the contract according to their specific needs. Common examples of OTC derivatives include swaps and forwards.

Main purposes: hedging, speculation and arbitrage

Derivatives are often used for specific purposes such as hedging, speculation and arbitrage.

• Hedging: this strategy allows the value of a position to be protected from unwanted market fluctuations.By using derivatives, an investor can offset any losses on his or her underlying investment with gains in the derivatives market.A typical example is a company buying call options to protect itself against a future increase in the price of a raw material needed for its production.
• Speculation: Derivatives also allow people to bet on the future trend in the price of the underlying asset.Speculators buy or sell derivatives with the goal of making profits by taking advantage of expected market fluctuations.
• Arbitrage: This is a more sophisticated strategy that exploits temporary price differences between the derivative and its underlying asset to make a risk-free profit. The mechanism is based on the principle that, at expiration, the price of the derivative and the underlying tend to coincide.

Practical examples of using derivatives

An example of using derivatives for hedging purposes might be a food company that wishes to purchase wheat in two months’ time. To avoid the risk of a price increase, the company could purchase call options on wheat at a set price.By paying a premium, it guarantees that the cost of purchasing the wheat will not exceed a certain limit, even if the actual market price rises.

An example of speculation, on the other hand, concerns an investor who buys a call option on gold with the goal of gaining from the growth in the price of gold. If at expiration the price of the precious metal exceeds the option’s strike price, the investor can make a profit.

The benefits and risks of derivatives

Derivatives offer many advantages, such as the ability to manage financial risks and broaden investment strategies.They make it possible to create positions that would otherwise be difficult or expensive to obtain in traditional markets. However, derivatives also carry risks, including market and counterparty risk, especially for OTC derivatives, where contractual flexibility does not provide the protection and standardization typical of regulated markets.

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