Derivative financial instruments: what are they?

Answering the question "what are derivatives?" is not difficult—derivatives are financial instruments whose value or price may fluctuate due to changes in the prices of related commodities or securities, currency exchange rates, interest rates, stock indices, credit ratings, or other elements. Derivatives represent financial instruments that create assets or liabilities and require little to no initial investment. Do you know what types of derivatives exist, when and how they are used, how they should be recorded in financial statements, and what risks they may carry? If you could not answer at least one of these questions, we invite you to keep reading to learn more about derivatives.

Types of Derivatives

Derivatives are essentially contracts between two or more parties, with prices that depend on the underlying asset’s price fluctuations. Typically, these instruments are purchased through intermediaries: brokers, various platforms, or agencies. In Lithuania, as around the world, derivatives are highly popular not only among individuals but also among legal entities, such as banks, corporations, and insurance funds. Derivatives can be categorized into two main groups: those traded on exchanges and those that are not. Each is further divided into four primary types: futures, options, swaps, and forwards.

Futures: These contracts allow buyers to purchase assets at a set price on a specified future date. Common users include farmers, miners, and other raw material producers seeking to minimize risk or maximize future profit on their products.
Options: Similar to futures, options contracts set an agreed price at which the asset can be sold. However, the buyer has the right, but not the obligation, to purchase the asset by a specific date.
Swaps (CFDs): These agreements allow two parties to exchange the price difference of an underlying asset. This instrument can be profitable whether the price increases or decreases, depending on whether the trader buys or sells.
Forwards: These are advance contracts requiring the buyer to purchase assets on a pre-set date at a pre-determined price. Companies often use them to hedge against interest rate and currency exchange risks.

While diverse, these types of derivatives share a common goal: risk mitigation, speculation on future asset trends, and income generation.

When Are Derivatives Used?

Derivatives in Lithuania are used for several purposes. The first goal is to manage investment risks. For instance, those wanting to guard against fluctuating interest rates and unpredictable outcomes often choose fixed-rate investment instruments. This includes platforms like Profitus, where investors can secure fixed returns, unaffected by market conditions, and know the exact return at the end of the term. Investments may also be aimed at increasing asset value and seeking profit, for which derivatives are an effective solution. Finally, derivatives can be used for diversification, helping investors spread risk.

How Are Derivatives Used?

As mentioned, derivatives in Lithuania are mainly used as insurance for assets, a means to generate additional income, or to increase asset value. They can protect against price fluctuations, smoothing adverse price movements. Short positions (selling borrowed assets) enable profits even when prices decline.

Speculation: Derivatives can be used to profit in bear markets by opening short positions when a trader expects the market to fall.
Income Generation: This is one of the riskier strategies, particularly with leverage, where traders only need to invest a portion (margin) of the position’s value. This can yield high returns, even from small investments, but also involves significant risk if the market moves unexpectedly.

Examples of Derivatives

The underlying assets of derivatives can be currencies, stocks, bonds, indices, commodities, or even cryptocurrencies. The value of derivatives is often influenced by fluctuations in these underlying assets, such as price, quantity, or exchange rates. However, in some cases, such as swaps, values may remain fixed. Below are some examples:

Forward Contract: Company A commits to purchasing goods from Company B for $100,000 five years from now, although Company A’s financial statements are in euros. To hedge against currency risk, Company A enters into a forward contract with a bank to buy $100,000 at an agreed exchange rate on a set date five years later.
Futures Contract: Farmer Jonas expects to harvest at least 100 tons of wheat by August. In January, the market price is €200 per ton, and to mitigate price risk, Jonas enters a future contract for the wheat at €200 per ton. If prices fall to €180, he still earns the contracted price.
Swap Contract: On January 1, 2024, Company A enters a three-year interest rate swap with Company B, where each borrows €100,000 at different rates. If the variable rate rises above the fixed rate (3%), Company B will pay Company A the difference, and vice versa if the fixed rate is higher.
Option Contract: Company A signs an option contract with a bank to purchase $100,000 for €112,750 by January 1, 2030. The company may exercise the contract if the rate is favorable.

Derivatives in Accounting

In accounting, assets or liabilities from derivatives should be recognized only when they meet recognition criteria or when it can be demonstrated that company resources will be used to fulfill the obligations. Assets or liabilities from derivatives should be recorded similarly to other financial instruments. Only executed transactions or commitments should be recorded.

Risks of Derivatives

Like any investment, derivatives carry risks, typically influenced by the volatility of the underlying asset, market conditions, or global events. To manage risk effectively, diversification is recommended. For example, one can diversify across sectors, including peer-to-peer lending platforms, stocks, or other derivatives, spreading investment over multiple avenues to manage exposure.