Understanding Derivatives: What They Are and How They Work

May 19, 2025 | 10 minute read

What are Derivatives?

A derivative is a financial contract whose value is derived from an underlying asset, such as a stock, cryptocurrency, commodity, currency, or index. Instead of directly buying or selling that underlying asset, you make an agreement about its value at a later time. You basically buy the right to a certain price. Derivatives are used to reduce risks.

Derivatives can be bought or sold in various ways, mostly through exchanges, but sometimes over-the-counter (OTC), meaning traded directly between two parties.

The value of a derivative moves with the price of the underlying asset. This makes derivatives flexible; investors use them to reduce risk in falling markets or to speculate and make profits.

Example:
Imagine you expect the price of oil to rise, but you don’t want to buy and store barrels of oil. Instead, you enter a contract giving you the right to buy oil at today’s price at a later date. If the oil price rises, you can sell the contract at a profit. If the price falls, you incur a loss. The contract itself is the derivative, and the oil is the underlying asset.

Derivatives are also widely used by companies wanting to reduce risk. For example, an airline might use a derivative to hedge against rising fuel prices, ensuring they don’t pay more than a certain amount even if market prices increase.

Trading derivatives involves risks, especially OTC contracts. These are less regulated and increase the risk that one party may default. There are ways to mitigate this risk, like using specific derivatives that lock exchange rates or interest rates.

Key Takeaways

Derivatives are financial contracts derived from other assets like crypto, stocks, currencies, or commodities.
They are used to hedge risks or speculate on price changes of the underlying asset.
Various types exist: options, futures, swaps, CFDs, and FRAs.
Benefits include risk reduction, leverage, access to new markets, and profit opportunities in falling markets.
Downsides are complexity, difficulty in valuation, and potential for significant losses.

Why Do Derivatives Exist?

Derivatives were developed mainly to limit currency exchange risks in international trade. Companies trading goods globally needed protection from volatile financial markets. Currency prices, like the Euro or Dollar, constantly fluctuate.

Example:
Suppose a European investor buys shares of an American company on a U.S. exchange. The purchase is in USD, but the investor holds euros (EUR). If the euro strengthens against the dollar, their returns (profit or loss) on the shares are affected by exchange rates independent of the stock price itself.

Derivatives can help here. The investor might use a currency derivative to hedge exchange rate risk, locking in a known return in euros regardless of dollar price changes.

On the flip side, derivatives can also be used to speculate. If the investor believes the euro will strengthen, instead of buying currency, they can use a derivative that gains value if the euro rises, making profits without owning the currency.

Companies Hedging Themselves

Think of a currency derivative as insurance against exchange rate fluctuations. A company paying in dollars but earning euros can hedge with a derivative. If the dollar suddenly gains value, the derivative offsets the difference, preventing unexpected costs.

Derivatives thus not only reduce risks but also allow profiting from market movements without owning the underlying assets.

Types of Derivatives

Common types include:

Options
Swaps
Futures
CFDs (Contract for Difference)
FRAs (Forward Rate Agreements)

These are the most well-known derivatives.

What is an Option?

An option is a right (not an obligation) to buy or sell an asset within a certain timeframe at a predetermined price. It’s a choice to exercise that buy or sell.

Options protect investments or allow speculation on price moves. For example: You own 100 shares worth $50 each, and you think the value will rise, but want protection against a drop. You buy a put option (the right to sell) at $50 — like insurance.

If the share price falls to $40, you can still sell at $50 due to the put. The option cost $2 per share (total $200), which is less than the $1,000 loss you avoided.

Conversely, if you don’t own shares but expect the price to rise, you buy a call option (right to buy) at $50. If the price rises to $60, you buy cheap and sell high, minus the option cost, making a profit.

The option seller must deliver if you exercise, but if the price doesn’t move in your favor, you let the option expire and the seller keeps the premium you paid.

What are Futures?

A future is an agreement between two parties to buy or sell a set amount of crypto (or another asset) at a fixed price in the future. It’s a kind of bet.

You might think Bitcoin's price will rise or fall and sign a contract accordingly. Regardless of the actual price later, both parties must honor the deal.

Two types of crypto futures:

Long: You think the price will rise.
Short: You think the price will fall.

Example: You go long on Bitcoin futures at $30,000. If Bitcoin rises to $35,000, you earn $5,000. If it falls to $25,000, you lose $5,000.

Leverage

Futures often use leverage, meaning you control a large position with a small amount of money. For example, $1,000 with 10x leverage controls $10,000 worth of futures. This boosts profits but also risks losing your entire investment.

Summary:

Futures are contracts to buy/sell crypto at a fixed price later.
Profit if you predict correctly; lose if not.
Leverage magnifies gains and losses.
Usually no need to own the actual crypto.

What is a Forward Rate Agreement (FRA)?

A FRA is a contract between two parties to fix an interest rate for a future period. It’s essentially a bet on future interest rates to hedge or speculate.

Example: A company knows it will take a loan in three months. Fearing rates will rise, it agrees now on a fixed rate for that loan in the future. If rates go up, it pays the agreed lower rate; if rates fall, it pays more than market but gains certainty.

Key Points About FRAs

Fix interest rates in advance.
Hedge against rate fluctuations.
No actual loan is exchanged via FRA.
Widely used by banks and companies sensitive to interest changes.

FRAs are rare in crypto but common in traditional finance, especially for large sums and interest derivatives.

What are Swaps?

A swap is a derivative where two parties exchange cash flows, commonly interest payments. For example, one party swaps variable interest payments for fixed payments.

Example:
Company A borrows $1,000,000 with variable interest (6%). Worried rates might rise, it agrees with Company B to swap variable for fixed 7%. Company B pays variable, Company A pays fixed. If variable rate rises above 7%, Company A benefits.

If Rates Change?

Variable drops to 5% → Company A pays difference to B.
Variable rises to 8% → Company B pays difference to A.

Company A achieves predictable fixed interest and less risk.

Swaps Go Beyond Interest

Swaps also cover currency risk, credit risk, mortgage cash flows, etc. Mortgage swaps were notably linked to the 2008 financial crisis due to counterparty risks.

What is a Contract for Difference?

A CFD lets you speculate on asset price changes without owning the asset. You agree with a broker to settle the price difference between opening and closing a position.

You can go long (bet on rise) or short (bet on fall). Profits/losses depend on price movement.

Example:

You open a long CFD on Bitcoin at $30,000. One week later, it’s $32,000 — you gain $2,000 without owning Bitcoin.

If price falls to $28,000, you lose $2,000.

CFDs usually involve leverage, increasing both potential profit and risk.

Pros and Cons of Using Derivatives

Cons

Valuation Difficulty: Derivative value depends on other assets and can be complex.
OTC Risks: Higher chance of default by counterparties.
Multiple Influencing Factors: Time to maturity, interest rates, storage costs.
No Intrinsic Value: Purely derived from underlying assets.
Leverage Risks: Can cause large losses, even for experienced traders.

Pros

Lock Prices/Rates: Protect against unfavorable moves.
Risk Diversification: Hedge exposure to currencies or commodities.
Leverage: Control large positions with small capital.
Access: Reach otherwise hard-to-access markets.
Profit from Downturns: Benefit in falling markets.

Final thoughts

Derivatives are financial contracts derived from other assets, used for hedging or speculation. Popular types include options, futures, swaps, CFDs, and FRAs. They offer benefits like risk management, leverage, and market access but carry risks that require understanding before use. Especially with leverage or OTC contracts, caution is necessary.