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Lesson 1 of 5 · 13 min
What a derivative is and how a contract is built
A derivative is a contract to exchange cash flows in the future, with an amount that depends on an underlying, so it reshapes the underlying's performance instead of simply passing it through.
In short
- A derivative is a financial contract whose value derives from the performance of an underlying: an asset, a group of assets, or a variable such as an interest rate or a credit index.
- Spot (cash) markets exchange assets now at spot prices; derivatives agree today on an exchange that happens later.
- Every contract names its counterparties, its underlying, its maturity (when it ends and settles), its contract size (notional) and a pre-agreed price.
- The buyer of a derivative gains exposure similar to a long position in the underlying; the seller has exposure similar to a short position.
- Settlement can be by delivery of the underlying or by paying the cash difference. Counterparty credit risk is the risk the other side cannot pay.
- A stand-alone derivative is a separate contract; an embedded derivative sits inside another instrument, such as a callable, puttable or convertible bond.
Spot markets versus derivatives
When you buy shares, bonds, currencies or a barrel of oil for immediate exchange, you are in a cash market or spot market, and you pay the spot price (cash price). Ownership and money change hands now.
A derivative is different. It is a contract between two parties to exchange cash flows at a future date, and the size of that exchange is set by an underlying value. The derivative's value is therefore derived from how the underlying performs.
The underlying need not be a single asset. It can be a basket of standardized assets (a stock index, a list of deliverable bonds) or a variable that is not an asset at all, such as an interest rate or a credit index.
Crucially, a derivative does not just copy the underlying's return. It transforms it: a forward locks in a price, an option keeps only the favourable side, a swap converts one stream of payments into another.
Think of a derivative as a side bet whose stake is written in the contract and whose outcome is decided by something else: the underlying.
A forward contract from start to finish
The simplest derivative is a forward contract: a one-time exchange of an underlying at a fixed price on a fixed future date. Suppose Lindqvist Asset Management in Stockholm owns 2,000 shares of a Swedish industrial company and fears a fall. Today (t = 0) it agrees with a bank to sell the 2,000 shares in three months (t = T) at SEK 150 each.
Lindqvist has transferred the price risk of the shares to its counterparty, the bank. Whatever the share price is in three months, Lindqvist will receive SEK 300,000 for the shares.
If the share price at maturity, , is SEK 138, the shares are worth only SEK 276,000. Lindqvist can either deliver the shares and receive SEK 300,000, or cash-settle by receiving the SEK 24,000 difference and keeping the shares. Both leave it with SEK 300,000 of value. If were SEK 162, Lindqvist would instead owe the bank SEK 24,000.
Derivatives usually involve at least one financial intermediary (a bank or dealer) as a counterparty. Because each side is promising to pay later, the chance that the other side cannot meet its obligations, counterparty credit risk, matters for every derivative.
The features every derivative has
A derivative is a legal agreement between counterparties. Its key terms are usually summarized in a term sheet before the trade is documented (for OTC trades, typically under an ISDA master agreement with agreed credit terms).
The buyer of a derivative holds a position whose value moves like a long position in the underlying; the seller holds the equivalent of a short position. In the forward above, the bank is the buyer and Lindqvist the seller.
The contract size, also called the notional principal or notional amount, is fixed at the start. It may stay constant over the contract's life or change on an agreed schedule.
| Feature | Meaning | In the example |
|---|---|---|
| Contract type | Firm commitment or contingent claim | Forward: firm commitment |
| Counterparties | Legal entities that enter the contract | Lindqvist (seller) and the bank (buyer) |
| Underlying | Asset or variable that drives the value | Shares of a Swedish industrial company |
| Contract size | Amount used to price and value the contract | 2,000 shares |
| Price | Pre-agreed price for settlement | SEK 150 per share |
| Maturity | Final date when settlement occurs | Three months from today |
Stand-alone and embedded derivatives
A stand-alone derivative is a distinct contract, such as a forward on a share, an option on an index or a swap on an interest rate. Lindqvist's forward is stand-alone.
An embedded derivative sits inside another instrument. A callable bond gives the issuer an option to repay early; a puttable bond gives the investor an option to sell the bond back; a convertible bond gives the investor an option to swap the bond for shares. The bond and the option are bought together as one security.
- Stand-alone: separate contract, e.g. a currency forward or a listed index option.
- Embedded: part of another security, e.g. the call feature in a callable bond.
Worked examples
Example 1 Settling a forward
Lindqvist agreed to sell 2,000 shares at SEK 150 in three months. At maturity the share price is SEK 162. What happens under physical delivery, and what is the cash settlement amount?
Example 2 Reading a term sheet
A term sheet says: Kowalczyk Foods (buyer) and Baltic Bank (seller) agree that in six months Kowalczyk will buy 500 tonnes of wheat at EUR 230 per tonne. Identify the counterparties, underlying, contract size, contract type and who has the long exposure.
On the exam
Expect definition questions (what a derivative's value is based on, what an underlying or counterparty is), fill-in-the-blank items on contract features, and classification of stand-alone versus embedded derivatives.
- Thinking a derivative passes the underlying's return straight through. It transforms that return according to the contract terms.
- Assuming the underlying must be a tradable asset. Interest rates and credit indexes are underlyings too.
- Mixing up roles: the derivative buyer is the long side, the seller the short side.
- Forgetting embedded derivatives: a callable or convertible bond contains a derivative even though no separate contract exists.
Check yourself
Q1Market participants use derivatives to exchange cash flows in the future based on a(n):
Q2A legal entity that enters into a derivative contract is best described as a:
Q3An investor agreed to sell 1,000 shares forward at EUR 40. At maturity the share price is EUR 36. Under cash settlement, the investor most likely:
Q4The buyer of a derivative contract has exposure most similar to:
Q5Which of the following is an embedded derivative?
Answer the 5 questions: +10 XP for each one you get right first time.
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