Derivative Product
It’s more than just “based on another asset” [here’s what a derivative product is.]
In school and across most internet sources, derivative products are defined as financial instruments whose value depends on an underlying asset. While technically correct, this definition is vague and unhelpful. It doesn’t tell you what a derivative is or how it works in practice.
If you’re preparing for a job interview or trying to truly understand financial markets, repeating that textbook phrase won’t cut it. Our goal with this article, we will give you a clear definition of derivative products, present the two main types, and highlight the key differences between them.
So, what is a derivative product?
Definition of derivative product
A derivative product is a financial contract whose terms are set today, but whose value will be determined at a future date based on the performance of an underlying asset. They’re also known as forward contracts.
For example, Oil is essential for running aircraft, which makes its price volatility a risk for Airbus. To hedge against the possibility of rising oil prices, Airbus can enter into a contract with a bank. This contract would specify that, if oil prices increase in three months, Airbus will still be able to purchase it at a price agreed upon today.
Airbus is entering into an agreement where the value or payoff of the contract depends on the future price of oil. The contract’s terms are fixed today, but the actual gain or loss will be realized later, depending on how the price of oil moves. The underlying asset in this case is Oil. We distinguish between two main types of derivative products: conditional derivative and Unconditional derivative.
Conditional derivative
As the name suggests, a conditional derivative is a type of financial contract that is conditional in nature. It gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specific time frame. Because the holder is not required to act, the payoff depends on whether they choose to exercise that right. The most common example of a conditional derivative is an option contract (calls and puts).
Get Jumbong Junior Quantitatif analyst’s stories in your inbox
Join Medium for free to get updates from this writer.
For example, suppose Airbus signs a call option contract that gives it the right to buy oil in six months at a fixed price of €52.5 per barrel.
- If, in six months, the market price of oil rises to €60, Airbus can exercise the option and buy oil at the agreed lower price of €52.5. In this case, Airbus saves €7.5 per barrel, effectively realizing a financial gain.
- On the other hand, if the market price drops below €52.5, say to €45, Airbus can simply choose not to exercise the option. Since it’s not obligated to buy, it can purchase oil directly on the open market at a cheaper price.
In the case of a conditional derivative, since Airbus is not obligated to exercise the contract, the contract is not free. A price must be paid upfront to acquire this right. This price is called the option premium.
This is a key characteristic of conditional derivatives: they are not free contracts. The premium reflects the value of the flexibility they offer to the buyer.
UnConditional derivative
Unlike conditional derivatives, there is no choice or flexibility for either party once the contract is signed. Both are obligated to fulfill their end of the agreement when the contract matures. These are commonly known as forward contracts, and when traded on organized exchanges, as futures contracts.
Let’s consider Airbus again. Since oil prices are unpredictable and fuel is a major operating cost, Airbus may want to lock in the price of oil today to avoid the risk of future increases.
To do this, Airbus can enter into a forward contract with a bank. The contract specifies that, in three months, Airbus will buy a certain quantity of oil at a fixed price of €52.5 per barrel, regardless of the market price at that time.
- If the market price of oil rises to €60, Airbus still pays €52.5. It gains €7.5 per barrel compared to the spot price.
- If the price falls to €45, Airbus still has to pay €52.5 as agreed. In this case, it loses €7.5 per barrel compared to buying on the open market.
In the case of an unconditional derivative, both parties are legally obligated to execute the contract at the agreed price and date, regardless of how the market price of the underlying asset changes. Because neither party has optionality, no premium is paid upfront. The contract itself is entered into at zero initial cost, and gains or losses are realized at maturity based on the market outcome.
This is a key characteristic of unconditional derivatives: they are binding contracts with no upfront premium. The risk is symmetric. Both parties are exposed to potential gains or losses, depending on how the underlying asset’s price evolves.
