Definition and taxonomy of derivatives
Definition of derivatives
A derivatives is a financial product, whose price derives from the price of another product.
- A corn futures is an exchange-listed contract, whose price depends of the rice of the corn bushel (in the physical market).
- The SPY, the ETF based on the S&P 500, is a stock-like instrument, whose price depends on the price of the 500 stocks composing the S&P 500 index.
- A USD/Euro option, is a contract, which gives the right (not the obligation) of trading the USD/Euro exchange rate at a pre-agreed price.
All these instruments are derivatives. Their prices depend on the spot prices of corn, stocks or the USD/Euro exchange rate. They also depend on other parameters.
Taxonomy of derivatives
We tend to classify derivatives along the following dimensions:
By their underlying, and often by the asset classes of the underlyings:
- Commodities: agricultural products (Corn, wheat, pork bellies…), oil & gas (crudes and refined), metals (copper, aluminium…), precious metals (gold, silver, platinum…), etc
- Fixed income: interest rates, from short dated to long bonds, in all currencies, as well as the currencies themselves.
- Equities: stocks, ETFs, for most countries.
By their legal structure:
- Contracts: agreements between parties, listed on an exchange or over the counter
- Debt, aka “debentures”: bonds (corporates, governments, municipalities, supra-nationals…), but also structured notes or convertible bonds.
- Equities: company stocks, but also fund units, MLPs.
BTW, each of these legal forms may or may not have counterparty risks:
- An OTC forward contract has counterparty risk, while a listed futures contract which is virtually the same payout has no counterparty risk.
- An ETF may contain counterparty risk on the issuer, even if the issuer is listed on the exchange.
- A debt instrument (including structured notes) has counterparty risk. Ask the holders of Lehman note what Lehman’s bankruptcy meant for them… pennies on the dollars…
We also classify derivatives by the optionality of their payouts:
- Linear or “Delta One”: Many derivatives do not give you a choice, and are their price end up linearly dependent to the price of their underlying. It is the case for futures, forwards, swaps, ETFs…
- Convex or “optional”: when the derivatives gives you a choice, like the right to exercise/buy/sell or the right to select among a list (best-of, worst-of…), the value of the derivatives becomes non-linear (convex). The derivatives becomes also dependent on the volatility of the underlying(s). Calls, puts and all the options are convex derivatives.