Derivative assets

Initially, markets in anything meant trading directly in assets. Still, over time the development of the economic system has led to the fact that there is a whole range of derivative assets that help in solving many specific issues.

All derivatives are referred to by a collective term - derivative.

Derivatives are financial contracts whose value is linked to some underlying asset (or group of assets) from the derivatives market - stocks, cryptocurrencies, bonds, etc. Legally, a derivative is a contract between two or more parties, and its price is formed due to fluctuations in the underlying asset's value.

Technically, the derivatives market is similar to the securities market but differs in that the seller and buyer are not required to own the asset directly.

Originally, derivatives were only futures and options. They were created to insure against risks. The conclusion of such an additional contract protects the investor from sudden changes in the asset price. However, today futures and options are actively used as speculative instruments.

Let's look a little more closely at what the leading derivatives are in the market.

Futures

Futures can be considered a "pre-order", i.e. a contract to buy/sell an asset at a predetermined price in the future. For example, the first futures were created specifically for the grain market, when farmers and grain processors needed to forecast the cost of raw materials in advance, even before the field was sown and the crop was harvested.

Term futures fix future deliveries' prices and allow businesses to avoid additional costs. When entering into a futures contract, the parties agree to transact a certain quantity of goods (contract size) at a certain time in the future (delivery date or expiry date) at a certain price (delivery price).

However, in modern realities, this instrument has moved somewhat updated from the commodity market to the financial market. For example, cryptocurrency exchanges have a particular type of futures contracts - open-ended contracts. Contracts with no delivery date mean no obligation to buy and sell the asset at a specific date.

At the same time, any futures contract has its main property - its seller does not need to keep the asset available when selling it. In a sense, trading in open-ended futures looks like "air trading", which is close to the value of the underlying asset, but in reality, is not secured by it and is not legally bound to it.

Forwards

This is a separate type of futures traded on over-the-counter markets. They do not have any standards and rules, the exchange does not act as an intermediary, and the transaction is made directly between the parties to the deal.

In a sense, buying cryptocurrency through an exchange looks like a forward; the delivery date is usually from a few minutes to a couple of hours. OTC market participants agree on the transaction, stipulating the selling price in advance, after which the exchange "issues a forward to the buyer" (i.e. publishes the terms of the order) and, after receiving funds from the user, delivers the cryptocurrency.

Instead of exchanges, aggregators exist for such participants.

The largest OTC aggregator in the stock market is the US NASDAQ and the largest OTC aggregator in the cryptocurrency market is BestChange monitoring.

Options

An option is the right to buy or sell at a specific price in the future. Unlike a future, where both parties are obligated to make a transaction in the future, an option only gives a right, not an obligation. That is, if it is not favourable for the buyer of an option to complete the transaction, he can simply walk away from the transaction. But the seller will be obliged to sell the goods at a price agreed upon in advance, regardless of his desire.

For such contracts, sellers take some commission (premium) at the moment of its sale. If we make an analogy, options are like asking a shop to "hold" goods for you for a small prepayment. Depending on the direction of transactions by the trading parties, options are divided into call options (giving the right to buy an asset at a fixed price on a predetermined day) and put options (giving their buyers the right to sell investments at a predetermined price at a predetermined time).

If the buyer doesn't guess the trend, he can back out of the deal. And the seller of the option will also not suffer severe losses because he will receive compensation (premium).

In addition to standard derivatives, there are other derivative assets.

Mutual Investment Funds (MIF)

Mutual funds imply the purchase of a share (unit) in a common fund, which is transferred to the trust management of a special organization to receive profit from their successful work.

Mutual funds operate based on internal rules. They fix the conditions under which depositors transfer financial resources to the management company, the criteria for selecting financial assets and their purchase strategy.

Such funds allow you to profit from the activities of professional analysts from significant investment funds and banks.

Exchange-traded investment funds (ETF)

They are almost a complete analogue of mutual funds, with the only difference being that shares in such a fund are traded on the stock exchange. You do not need to go to the fund and buy it directly from them to buy a share, but you can make such a transaction now on the stock exchange.

Wrapped token (wrapped token)

Another atypical form of derivative asset is a "wrapped token". Legally, it is a complete copy of some crypto-asset issued on some blockchain (usually another) against the original cryptocurrency.

For example, the most famous wrapped token is Wrapped Bitcoin (WBTC). Such a token is issued on the Ethereum network and is tied to the value of the bitcoins stored in the reserve fund wallet. Thanks to the "wrapped" version of bitcoin, it became possible to work with it in decentralized finance (DeFi) and use it in other variants of smart contracts.

And the most unexpected manifestation of "wrapped tokens" is WETH - an ether copy on the Ethereum network. A seemingly completely pointless thing, but that's not entirely true. The fact is that many smart contracts from the world of decentralized finance are designed for the ERC-20 token standard. At the same time, the blockchain uses completely different features to work with Ethereum itself. Because of this feature, for the sake of the universality of smart contracts, it was necessary to "wrap" Ethereum, turning it into an ERC-20 copy in its blockchain.

Stablecoins

In a sense, stablecoins can also be considered a variant of the "wrapped token". However, they use the means of the traditional financial market (bank accounts, bonds, pledges, etc.) to reserve assets.

You can read more about stablecoins in our material: How to choose the right stablecoin?

As you and I have seen, the derivatives market can be exchange-traded and over-the-counter. In the exchange-traded market, standardized contracts are traded in terms of volume and maturity, and transactions are concluded with a central counterparty. The OTC market represents the whole aggregate of sellers and buyers, and there are no generally recognised standards here, although all participants try to adhere to the usual rules.

With the help of derivative instruments, it is possible to insure against the situation when the price will not go in the desired direction or to get access to the tools of work with assets that were not originally planned.