Financial derivatives are contracts whose value depends on the price of another asset, such as a share, a currency, a stock market index, or any other type of asset. Their main function is to provide protection against risks.
Hearing the term "financial derivatives" may sound complex, even speculative. But the reality is quite different: derivatives can be very useful tools for protecting an investment portfolio against market risks such as currency fluctuations or stock market volatility. Let’s look at how they are used.
The most well-known financial derivatives are futures (contracts to buy or sell something at a future date for an agreed price), options (which give the right, but not the obligation, to buy or sell something in the future at a set price), and swaps (exchange contracts to swap future cash flows). While they can be used for speculative purposes, their main advantage lies in risk management.
A very common example is the use of a financial derivative in the form of a currency future or forward. This tool allows the investor to limit or eliminate the risk from currency movements over a time period matching the investment.
Hedging against currency risk with derivatives
An investor decides to buy a corporate bond denominated in US dollars with a 6% coupon and a three-year term. The catch is that the investor operates in euros and needs to exchange this currency for US dollars. At this point, two possible routes open up: buying the bond without protecting against potential euro/dollar exchange rate fluctuations, or opting for protection.
If the investor chooses not to hedge and the euro goes up against the dollar over the three-year period, then when the gross returns are received — that is, 6% annually over three years — the actual profit will be much lower. In other words, if the investor exchanged €100,000 for dollars at a rate of 1.05 when purchasing the bond, they would receive $105,000. On that amount, they’d earn a $6,300 annual coupon. After three years, if the exchange rate moves to 1.13, the total of $123,900 converted back to euros would yield only €109,199. The total return, instead of being 18%, would be just over 9%.
However, if that same investor purchases a financial derivative in the form of a currency future to lock in the exchange rate, they secure the ability to convert the dollars back into euros at a fixed rate, say 1.05 or 1.07. Of course, the final return would also be slightly lower than 18% due to the cost of the hedge, which can vary, but the currency risk would be significantly minimized.
The importance of currency risk
The previous example illustrates how currency risk can cut expected returns by 50%. The same applies when investing in stocks listed in a market that uses a different currency. For this reason, and particularly in certain investment strategies, it is more prudent to seek protection, whereas in others, the impact may not be as significant.
Currency risk is greater with products like fixed income, which typically offer lower and more predictable returns. On the other hand, for long-term equity investors, the impact may be less pronounced. Still, depending on the investor’s profile and strategy, financial derivatives can also be used for protection.
To cite a very real example: this year alone, the euro/dollar exchange rate moved from 1.03 to 1.15. During the same period, the S&P 500 index dropped by 8%. However, for an investor based in euros, the actual loss — combining the drop in the index and the impact of currency movement — exceeded 16%.
Hedging against stock market downturns with derivatives?
Another commonly used strategy for protection with financial derivatives involves the well-known financial options. These types of contracts give the investor the right to buy or sell a specific asset at a predetermined price. A simple example can help clarify how these options work in practice:
Suppose an investor holds €100,000 in shares of a particular company, or an index, and believes it may fall in the coming months. In this case, put options could be an effective strategy. Instead of selling the assets, because she follows a long-term strategy and simply wants to protect herself against a potential decline, she decides to buy a put option, which gives her the right to sell the index or the share at the original price over the course of the next year.
If the market does in fact fall by 18%, the option gains value because the index has dropped, and she only needs to sell the put option — there’s no need to sell her underlying asset, which remains in her portfolio for the long term. If the market doesn’t fall, she would only lose the amount paid to purchase the option, known as the premium. In other words, options work like “insurance.”
There are many types of financial options, though the two most common are put and call options, the latter of which work in the opposite way to the example given. As we've seen, the purpose of options for investors or portfolio managers is to provide protection, acting as a kind of insurance to limit market losses.
