What a derivative is, who uses it, and why it is risky
◈ 7 cardsA contract whose value comes from something else; hedgers, speculators and arbitrageurs on the two sides of the same trade; and leverage — a small performance bond controlling a large notional.
A contract on something else
A derivative is a contract whose value is derived from an underlying — a commodity price, a share, a bond, an interest rate, a currency, an index. The contract itself produces no lumber, pays no dividend, earns no interest; its worth on any day is a function of the underlying's price on that day. The four families this module covers are forwards, futures, options and swaps. Forwards and futures are obligations to trade at a fixed price on a future date; options are rights; swaps are exchanges of cash-flow streams.
Three users of the same contract
Northshore Timber will cut 110,000 board feet of lumber this autumn. If the price falls before it sells, the season's profit is gone. It sells lumber futures today at the current futures price: whatever spot does, it has locked its selling price. Northshore is a hedger — it holds the underlying (or will), and takes the derivative position that offsets that exposure. A hedger reduces risk.
A commodity fund expects lumber to rally and buys the same futures. It owns no timber; it simply wants the exposure. The fund is a speculator — it takes on the risk the hedger is shedding, hoping to be paid for it. The contract Northshore sold is the contract the fund bought: one side hedges, the other bets, and the market needs both.
A dealer's arbitrage desk notices that Lakehead Robotics, interlisted on the TSX and the NYSE, trades for a moment at the equivalent of $44.90 in Toronto and $45.10 in New York. It buys in Toronto and sells in New York simultaneously. It is an arbitrageur — it earns a riskless profit from a price discrepancy, and in doing so removes it. Arbitrage is why the same asset has one price.
Why derivatives are called risky — leverage
An index futures contract has a notional value of $100,000 — the value of the index basket it represents. To hold it, the fund posts a performance bond (futures margin) of $5,000. It controls 100,000 of exposure with 5,000 of capital:
Now the index moves 2 %. On the notional that is =100000*0.02 = $2,000 — a small move in dollars. But on the fund's 5,000 it is =2000/5000 = 40 %. A 5 % move against the fund wipes the bond out. That is the risk: derivatives do not amplify the dollar move — 2,000 is 2,000 — they amplify the percentage move on the capital committed. The same leverage that lets Northshore hedge a season's output for a fraction of its value lets a speculator lose more than they posted.
The Canadian canvas
Exchange-traded derivatives in Canada are listed on the Montréal Exchange (MX) — equity and index options, index futures, CORRA and Government of Canada bond futures — and cleared by the Canadian Derivatives Clearing Corporation (CDCC), MX's wholly owned central counterparty. Shares clear through CDS; derivatives through CDCC. The TSX lists shares, not derivatives. Forwards and most swaps are over-the-counter — private contracts with a bank or dealer, no exchange, no clearinghouse (Lesson 12.2).
Recompute
The same $100,000 contract on a $4,000 performance bond: leverage =100000/4000 = 25×; the 2 % move is still 2,000, now 50 % of the bond. Classify cold: an airline buying jet-fuel futures — hedger; a trader shorting them on a forecast — speculator; a desk buying the futures and selling the physical when they misprice — arbitrageur.