Foundations of Derivatives: Concepts, Categories & Intuitive Examples

A derivative is a financial contract whose value depends on one or more underlying assets. Traders use derivatives to hedge risk, speculate on price movements, or gain leveraged exposure. These instruments allow traders to reach specific market positions at a lower cost and with greater flexibility than using the underlying assets directly.

Derivatives fall into two main categories: forward claims and contingent claims. Forward claims obligate both parties to follow the agreed terms throughout the contract’s life. Contingent claims, such as options, give the holder the right but not the obligation to buy or sell an asset at a set price before expiration.

Example to understand derivatives

An apple farmer expects a harvest in 3 months, and fears apple prices might fall. A juice factory needs apples in 3 months, and worries prices might rise, increasing its costs.

 THE AGREEMENT:

To protect themselves against price fluctuations, the farmer and the factory enter into a forward contract today. They agree that in 3 months, the factory will buy 1,000 kilograms of apples at a fixed price of $2 per kilogram from the farmer.

This contract is a financial derivative, because its value is derived from the future price of apples.

Let's assume the CASE OF the MARKET PRICE OF $2.50/KG.

The factory benefits: It pays only $2/kg, lower than the market price. The farmer misses out on the higher price he could have gotten.

The underlying asset is apples. The derivative is the futures contract based on the price of apples. Both parties use the contract to manage risk. The farmer protects against falling prices, and the factory protects against rising prices.

The most used derivatives are :

A futures claim arises from a standardized futures contract, an agreement between two parties to buy or sell an asset at a predetermined price on a future date. Futures are traded on exchanges, and traders use them either to hedge price risk or to speculate.

A central clearing house (CCP) stands between buyers and sellers. The CCP guarantees performance by acting as the buyer to every seller and the seller to every buyer, thereby reducing counterparty risk. Futures are also marked to market (MTM) daily, meaning gains and losses are settled in cash each day as the contract value changes.

A forward claim works similarly but occurs in over-the-counter (OTC) forward contracts. Forwards are private agreements, not standardized, and allow complete customization of terms, size, maturity, and settlement method. Because no CCP is involved, each party bears the counterparty risk. Forward claims reflect the obligation of each side to perform under the agreed contract at maturity.

A swap claim refers to the contractual right to receive net payments under a swap agreement. It is more of a legal concept that describes the enforceable obligation owed by a counterparty during the life of the swap or upon default or early termination.

If you’d like to explore the more advanced side of derivatives, including how swaps work, why option styles matter, and what risks traders must watch out for, you can continue reading in the following article, click here.

Authored by: Paul Thomas George, FLC.