What are derivative contracts and how do they work?

The Saudi stock exchange (Tadawul) announced today that it was in the process of selecting a handful of listed companies to be included in the burgeoning derivative market in Saudi Arabia.

Below is a brief explanation of derivatives, their types and how they work:

A derivative is a financial contract that derives its value from its relationship with another (underlying) asset or cash flows.

In a derivative contract, the buyer agrees to purchase an asset on a specific date at a specific price.

The contract's seller does not have to own the underlying asset. He can fulfill the contract by giving the buyer enough money to buy the asset at the prevailing price at the time of purchase. Or he can give the buyer another derivative contract that offsets the value of the first. This makes derivatives much easier to trade than the asset itself.

Derivatives are often used for the exchange of commodities, such as oil, gasoline, or gold; or currencies, often the U.S. dollar.

Types of Derivatives

There are several types of derivatives, the most common of which are listed below:

1) Futures contracts: One of the most common types of derivatives. A futures contract (or simply futures) is an agreement between two parties for the sale of an asset at an agreed upon price.

This contract is used to hedge against risk during a particular period of time.

2) Forward contracts are similar to futures contracts, the key difference being that unlike futures, forward contracts (or forwards) are not traded on exchange, rather they are traded over-the-counter.

3) Swaps: A contract between two parties agreeing to trade loan terms. One might use an interest rate swap to switch from a variable interest rate loan to a fixed interest rate loan, or vice versa.

4) Options: An option is similar to a futures contract in that it is an agreement between two parties granting one the ‘opportunity’ to buy or sell a security from or to the other party at a predetermined future date.

The key difference between options and futures is that with an option, the buyer is not obligated to make the transaction if he or she decides not to, hence the name ‘option.’

The key difference between options and futures is that with an option, the buyer is not obligated to make the transaction if he or she decides not to, hence the name ‘option.’

Saudi Arabia is planning to begin with Stock Index Futures as a type of derivatives, then delve into more products as the market matures.

“Index-futures is the first derivative product to be introduced in local market, then several products will follow, including options,” said Khalid al-Hussan.

Global derivative market

Over 90 percent of the world's 500 largest companies use derivatives to fulfill future needs and manage risks. A futures contract promises delivery of raw materials (for example) at an agreed-upon price on a certain date in the future.

By signing such contract, the company is protected if prices rise. Companies also write contracts to protect themselves from changes in exchange rates and interest rates.

Derivatives make future cash flows more predictable. They allow companies to forecast their earnings more accurately. That predictability boosts stock prices. Businesses then need less cash on hand to cover emergencies. They can reinvest more into their business.

Derivatives have a large risk profile, predominantly because it is almost impossible to know the real value of any derivative. That is because it is based on the value of another underlying asset.