What derivatives are and why they exist: hedging versus speculation

What you will learn

• What a derivative is and which terms describe every derivative contract
• The main families: forwards, futures, options, swaps, CFDs and certificates
• The difference between hedging, speculation and arbitrage
• Why a hedge removes upside as well as downside

Explanation

A derivative is a contract whose value is derived from the price of something else, the underlying: a share, an index, a currency pair, an interest rate or a commodity such as wheat or oil.

Every derivative has a few basic elements:

• Counterparties: the two sides. The long side usually benefits if the underlying rises, the short side if it falls.
• Notional value: the value of the underlying the contract controls, for example 500 tonnes of wheat at €200 per tonne = €100,000 notional. You usually pay far less than the notional to open the position. This is leverage, which you met in the Risk Management course.
• Maturity or expiry: the date on which the contract ends.
• Settlement: how the contract is fulfilled at the end, either by physical delivery of the underlying or by cash settlement (only the money difference is paid).

The main families

• Forward: a private agreement to buy or sell an underlying at a fixed price on a future date. Both sides are obliged.
• Future: a standardised forward traded on an exchange and guaranteed by a clearing house (lesson 2).
• Option: the right, but not the obligation, for the buyer to buy (call) or sell (put) at a fixed price (lessons 4 to 8).
• Swap: an exchange of payment streams, for example fixed against variable interest, used mainly by companies and banks.
• CFD (Contract for Difference) and certificates such as warrants and knock-outs: retail products issued by brokers or banks (lessons 9 and 10).

Three motives

Hedging means taking a derivative position that offsets a risk you already have. A farmer who will harvest wheat is naturally long wheat. Selling wheat forward reduces that existing exposure.

Speculation means taking a position to profit from an expected price move, without an existing exposure to offset. The speculator creates new risk.

Arbitrage means exploiting a price difference between related instruments, for example a mispriced future (lesson 3). It keeps derivative prices close to their underlying.

Before costs, a derivative is a zero-sum contract: what one side gains, the other loses. After fees and spreads, the sum for both sides together is negative. A hedger can accept a "loss" on the contract because it offsets a gain in the business; for a speculator, every euro of profit is someone else's euro of loss.

Worked example

Hypothetical example: a farmer expects to harvest 500 tonnes of wheat in four months. A mill needs 500 tonnes at the same time. They agree a forward contract at a hypothetical price of €220 per tonne. The farmer is short the forward, the mill is long. Assumptions: no fees, no transport costs, no default by either side.

Scenario A: the market price falls to €190 per tonne.

• Farmer sells the wheat at the market: 500 × €190 = €95,000.
• Gain on the short forward: (€220 − €190) × 500 = €15,000.
• Total for the farmer: €95,000 + €15,000 = €110,000.

Scenario B: the market price rises to €250 per tonne.

• Farmer sells at the market: 500 × €250 = €125,000.
• Loss on the short forward: (€220 − €250) × 500 = −€15,000.
• Total for the farmer: €125,000 − €15,000 = €110,000.

In both cases the farmer receives €110,000 (500 × €220). The hedge removed the downside and the upside; the mill always pays an effective €110,000.

A speculator in the mill's place, with no need for wheat, would lose €15,000 in Scenario A and gain €15,000 in Scenario B. The same contract reduces risk for one side and creates risk for the other.

Common mistake

Practice activity

On paper, classify each situation as hedging, speculation or arbitrage. Then answer the calculation.

1. A German company will receive $200,000 from a US customer in three months and sells dollars forward.
2. A trader with no shares buys index futures because she expects a rally after a central bank meeting.
3. A bank buys an index and sells the index future at the same time because the future trades well above its fair value.
4. Calculation (hypothetical): an olive oil importer agrees to buy 10,000 litres forward at €8.00 per litre. At delivery the market price is €9.20. What is the gain or loss on the forward, and what is the effective cost per litre?

Key takeaways

• A derivative is a contract whose value depends on an underlying; notional value is usually much larger than the money you put down.
• Hedging offsets an existing risk; speculation creates new risk; arbitrage keeps prices aligned.
• A hedge fixes the outcome: it removes the upside as well as the downside.
• Before costs derivatives are zero-sum; after costs they are negative-sum for the two sides together.

Next step

In the next lesson you will see how exchange-traded futures standardise the forward contract and how daily settlement and margin work in practice.