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What is meant by derivatives? Does it affect me as a small investor?

The Bigger Picture

Derivatives, as their name suggests, derive most of their value from an underlying asset or security, the balance of their value comes from the inherent rights attached to them and the lifetime of such rights. Derivatives are used by institutional investors for a variety of reasons including risk reduction and arbitrage. While they are less common in an individual's portfolio, they are used by knowledgable investors to reduce risk and increase yield.

An option is a financial instrument that gives its holder the right to either buy or sell an underlying asset. The most popular type of option is one whose underlying asset is a stock. These types of options are referred to as stock options.

Options can be either "call" options or "put" options. Holders of call options have the right to buy an asset at a specific price within a specific time frame. Holders of put options have the right to sell an asset at a given price within a specific time frame.

Although options can be used to speculate, they are very popular instruments that can help investors, large and small, reduce risk.

A futures contract is a financial instrument that obliges the parties to the contract to either buy or sell an underlying asset at an agreed upon price on pre-determined date in the future. There are futures contracts on assets ranging from wheat to crude oil to government bonds. These contracts are primarily used by professional investors to manage risk.

Due to the high amount of leverage associated with futures trading they are generally unsuitable investment vehicles for small investors.

What Derivatives mean to the Average Investor

Although direct futures trading may be unsuitable for retail investors, futures and other derivative instruments are used to reduce risk and offer diversification within investment products that are quite suitable for the retail investor.

Here are three common investments that use derivatives or have derivative-like elements:

GICs:

You may have dealt indirectly with derivatives if you purchased a GIC. For example, bank GICs that pay based on the performance of a stock index. are derivative-based investments.

Mortgages:

If you purchased a floating-rate mortgage with an interest-rate cap, many of these products have derivatives built in.

Mutual Funds:

The most common product that retail investors own that are based on derivatives are "clone" funds. RRSP-eligible clone funds, designed to mirror the returns of foreign-equity funds, do so through the use of derivatives.

One example, used in many clone mutual funds, occurs by swapping Government of Canada treasury bills for the returns on a basket of foreign stocks. In this case, the fund company invests over 80 per cent of the portfolio, primarily in domestic fixed-income investments such as Government of Canada treasury bills, and the rest in futures contracts. By investing in these Canadian investments, they maintain 100 per cent RRSP eligibility, while mimicking the returns of a particular foreign fund.

Many index funds, on the other hand, use different securities to mimic a particular index and are, therefore, often more volatile. For example, some funds use index-based derivatives that experience the volatility of the particular index they are tracking, while others buy the actual stocks included in the index. If the stocks in the index experience a decline, so will the index fund, which we have seen happen recently.

But not all index funds should be painted in the same light. Some index funds, Barclay's iUnits for instance, use futures derivatives to offset market swings and may offer more stable returns.

Advantages and Disadvantages of Derivative-based Products

Pros:

The proper use of derivatives both directly and within investment products such as the ones discussed above can help investors reduce risk and increase returns.

Cons:

Directly trading derivatives for speculative purposes is high-risk and can lead to significant losses.