Investors use derivatives to hedge, speculate or increase their leverage, and there’s a growing basket of instruments to choose from. But it’s crucial that investors know the risks derivatives can pose for their portfolios.A derivative investment is one in which the investor does not own the underlying asset, but instead bets on the asset’s price movement with another party. It derives its value from the performance of the underlying asset, and the riskier that asset is, the riskier the derivative. Investors typically use derivatives to hedge a position, for leverage, or to speculate. Hedging protects investors against an asset’s risk. For example, an investor may buy a put option on a stock she owns to protect against the chance the stock’s value will fall. In volatile markets, an option can provide leverage, especially when the price of the underlying asset moves in a favorable direction. And speculating lets investors bet on an asset’s future price. Derivatives are bought over the counter or on an exchange. An OTC derivative, which is made between two private parties, is unregulated and features counterparty risk. Types of derivatives include options, swaps, and futures or forward contracts. Options provide the right to buy or sell an asset. They offer insurance against large price movements in an asset. In swaps, counterparties exchange cash flows or other investments. Many times swaps occur because one party has access to better interest rates while the other party can borrow more freely as the fixed rate. Interest rate, currency and commodity swaps are common instruments. Forward and future contracts are agreements to buy or sell an asset at a set price in the future. The difference in price provides one party in the deal a profit, and other a loss. Investors use them to hedge risk.
