What is a derivative?

Derivatives play a central role in financial markets and allow investors to speculate on the performance of underlying assets such as shares, bonds or commodities, or to hedge against price risks. They are versatile financial instruments that come in various forms – from options and futures to swaps. But what exactly is behind these contracts? We explain what a derivative is, what they mean and how derivatives actually work.

• Derivatives are financial instruments whose value is based on an underlying asset such as shares, bonds or commodities, and which are used for speculation or hedging.

• They function as contracts that regulate the future purchase or sale of an underlying asset under specified conditions.

• Key forward transactions include futures, options, swaps and forwards, which are traded either on exchanges or over the counter (OTC).

• Derivatives offer high opportunities but also involve risks such as leverage, credit risks and market volatility, especially in over-the-counter transactions.

Definition: Derivatives explained simply

Derivatives are, by definition, financial instruments whose value is based on an underlying asset such as shares, bonds, commodities or currencies. When the price of the underlying asset changes, the value of the derivative also changes. The term “derivative” comes from the Latin verb derivare and essentially means “to derive” or “to stem from something else”.

A derivative is a binding agreement between two parties that regulates the purchase or sale of an underlying asset under certain conditions. These financial products can be traded both on an exchange and over the counter (OTC – over-the-counter). The structure of a derivative enables investors to benefit from the performance of an asset without having to own it physically.

Some derivatives are securitised, meaning they are classified as securities and subject to specific regulatory requirements. An example of a securitised derivative is a warrant. Through securitisation, the asset becomes tradable and can be more easily converted into cash.

Not all derivatives are considered securities. A common distinction is made between exchange-traded derivatives, which are subject to strict regulations and fulfil reporting and clearing obligations, and OTC derivatives, which are traded directly between two parties without central exchange supervision. The labels and conditions of securitised derivatives are not always standardised. Investors should therefore examine the contract details carefully before purchasing a derivative.

Brief history and legal issues concerning derivatives

Derivatives have existed for centuries. As early as antiquity, traders in Mesopotamia and Greece used simple forward contracts to hedge against price fluctuations. In the 17th century, so-called rice futures were traded in Japan, where buyers and sellers agreed in advance on a price for a future delivery. In Europe, derivatives played a crucial role in commodity trading, especially in hedging agricultural products and raw materials.

With industrialisation and the expansion of financial markets, derivatives became increasingly complex. In the 20th century, modern futures and options exchanges emerged, making standardised derivatives tradable. In recent decades, the market for financial derivatives has expanded enormously, with products such as swaps, certificates and options used for various investment, hedging strategies and forward transactions.

Legal regulation of derivatives

Derivatives are subject to different regulatory provisions worldwide, depending on the type of derivative and the respective market. Exchange-traded derivatives such as futures and options are strictly regulated to curb market manipulation and excessive speculation. This regulation is carried out by financial market authorities such as the European Securities and Markets Authority (ESMA) or the US Commodity Futures Trading Commission (CFTC).

OTC derivatives, which are traded outside regulated exchanges, offer more flexibility but are associated with higher risks. The 2008 financial crisis showed that unregulated derivatives can have significant impacts on the global financial system. Since then, stricter regulations have been introduced, including higher transparency requirements, reporting obligations and clearing mandates for certain OTC products and off-exchange transactions.

Investors trading in derivatives should familiarise themselves with the applicable legal frameworks, tax implications and potential risks before making an investment.

Terms related to trading derivatives

Derivatives are versatile financial instruments used for both speculation and hedging against risks. Anyone trading in derivatives should be familiar with some basic terms.

Underlying asset

Every derivative is, simply put, based on an underlying asset, whose price movement determines the value of the derivative. Underlying assets can be shares, bonds, commodities, currencies or interest rates.

Hedging: protection against risks

Derivatives are used to hedge against price fluctuations. An example of such a forward contract: a bean farmer and a producer agree today on a fixed price for a future delivery to protect themselves against price changes. This hedge reduces potential losses, but it can also mean that one party forgoes additional gains.

Leverage

Many derivatives are leveraged, meaning investors can move a larger market position with relatively little capital investment. Leverage amplifies both gains and losses, which is why it carries high risks.

Long and short position

• Long position: an investor buys a derivative in anticipation of rising prices of the underlying asset

• Short position: the investor bets on falling prices and profits when the underlying asset loses value

Speculation and arbitrage

Speculators deliberately bet on price movements to achieve high returns, but also take on high risks. Derivatives such as futures and options are traded on the futures market, while securities like shares and bonds are traded on the spot market. Arbitrage, on the other hand, exploits price differences between markets or interest rate differentials to achieve risk-free profits – for example through swaps, where future cash flows are exchanged.

Types of Derivatives

Derivatives come in various forms, differing in structure, underlying asset and trading venue. They are traded either on an exchange or over the counter (OTC – over-the-counter). The main financial derivatives are warrants, futures, forwards, swaps and currency derivatives. Each of these financial products has its own characteristics suited to different investment strategies.

Warrants

A warrant is a securitised derivative that gives the holder the right, but not the obligation, to buy or sell an underlying asset such as shares, bonds or commodities at a set price (strike price) within a certain period.

• Call option: the holder can buy the underlying asset at a fixed price if they expect a price increase

• Put option: the holder can sell the underlying asset at a fixed price if they expect a price decrease

Warrants are often used for speculation, as they offer high profit potential. However, they can also involve significant risks, especially if the market does not develop as expected.

Futures

A futures contract is a binding agreement to buy or sell an underlying asset such as shares, commodities or interest rates at a specific price and time in the future.

• Exchange-traded: futures are standardised contracts traded on futures exchanges such as EUREX

• Leverage: futures offer high profit potential but also carry high risks

• Hedging: commonly used by companies and investors for protection against price risks

One example is an oil futures contract, in which the buyer and seller commit to trade a specific quantity of oil at a fixed price on a set date.

Forwards

Forwards are similar to futures but are OTC derivatives and therefore individually negotiable. They allow flexible contract terms between two parties but are less liquid than exchange-traded futures.

• Individually tailored: more flexible than futures, but without central regulation

• Higher counterparty risk: no central exchange, hence the risk that one party may not fulfil the contract

One example is a currency forward, where companies hedge against exchange rate fluctuations by agreeing today on a fixed exchange rate for a future transaction.

Swaps

A swap is a contract in which two parties exchange future payment streams (cash flows). Swaps are an important financial instrument for banks, companies and institutional investors.

• Interest rate swaps: exchange of a fixed for a variable interest rate, often to reduce interest rate risks

• Currency swaps: exchange of capital and interest payments in different currencies to hedge against exchange rate risks

Swaps are one of the most significant financial innovations of recent years, but are traded OTC, which allows individual contracts but also involves higher risks.

Currency derivatives

Currency derivatives refer to contracts based on exchange rates between currencies. They are used to hedge against currency risks or to profit from exchange rate movements.

• Forex futures: standardised contracts to buy or sell a currency at a set rate and time

• Currency options: rights to buy or sell a currency at a certain price

• Currency swaps: contracts to exchange capital and interest payments in different currencies

Currency derivatives play an important role for companies and investors operating internationally who want to hedge against currency fluctuations.

How do derivatives work?

Derivatives are contracts between two parties based on a specific underlying asset and executed under agreed conditions in the future. Their value depends on the price development of the underlying asset. The most common underlyings include shares, commodities, currencies, interest rates and indices.

Derivatives are traded either on an exchange or over the counter (OTC). While exchange-traded derivatives have standardised terms and are strictly regulated, OTC derivatives offer more flexibility but also carry a higher default risk. Trading in derivatives allows investors to speculate on price changes, hedge against financial risks or benefit from market inefficiencies.

The price of a derivative is influenced by several factors. This includes the current market price of the underlying asset as well as future expectations. Volatility plays a crucial role, as greater price fluctuations often lead to higher derivative costs. External factors such as economic developments, interest rates and political events also influence pricing.

Depending on the market outlook and the derivative chosen, a position may target either rising or falling prices. While speculative investors aim to profit from targeted market movements, companies often use derivatives to hedge against financial uncertainty. For example, an internationally operating company may use currency derivatives to hedge against exchange rate changes.

Because derivatives are associated with high risks, investors should fully understand how they work and their specific terms before making an investment decision. Leveraged derivatives in particular can result in both high profits and disproportionate losses.

In addition to speculative and hedging derivatives, there are also products aimed at optimising short-term liquidity. Bitpanda Cash Plus allows investors to invest unused cash in money market-related financial products.

Why is there trading in derivatives?

Derivatives play a central role in financial markets as they enable investors to react to price movements without directly owning the underlying asset. They are used to manage risks, deploy capital efficiently or generate profits through speculation.

A key purpose of derivatives is hedging against price fluctuations. Companies use them to protect themselves from rising commodity prices, interest rates or currency risks. At the same time, traders use leverage to take larger market positions with relatively little capital.

Another reason for using derivatives is to forecast market developments. Especially with interest rate and currency swaps, market participants try to anticipate future interest or exchange rate movements. For instance, a bank may swap a fixed-interest claim for a variable one to benefit from interest rate changes or to hedge against fluctuations. The bank that better predicts the market can gain from the difference between the agreed rate and the actual interest obligation.

Besides these functions, derivatives provide additional liquidity and more efficient pricing in financial markets. They offer diverse opportunities but are also associated with high risks, so investors should gather detailed information before trading.

Advantages and disadvantages of derivatives

Derivatives have many applications, but they also involve considerable risks. While they can be used for hedging, speculation or arbitrage, they are also a type of investment that is often debated due to their complexity and volatility.

Advantages of derivatives

• Risk management: companies and investors use derivatives for hedging against price, interest rate or currency risks

• Leverage: larger market positions can be taken with little capital, potentially maximising gains

• Market efficiency: derivatives increase liquidity and improve price discovery in financial markets

• Flexibility: many OTC derivatives can be customised, allowing for targeted investment strategies

Disadvantages of derivatives

• High risks: leverage can lead to not only high profits but also disproportionate losses

• Complexity: derivatives are often difficult to understand, so they're mainly suitable for experienced investors

• Credit risk: especially with OTC-traded forwards and swaps, there's a risk that one party may not meet their obligations

• Lack of oversight: unregulated speculative trades, like those by Nick Leeson which led to the collapse of Barings Bank in 1995, highlight the risk of insufficient supervision

Frequently asked questions about derivatives

Want to learn more about derivatives, what they mean and how they work? Then check out our answers to the most common questions on the topic.

What does derivative mean?

A derivative is a financial instrument whose value is based on an underlying asset, such as shares, commodities or currencies. The price of the derivative changes in line with the value development of the underlying. Derivatives can appear as contracts between two parties agreeing on the future trade of a specific asset at a fixed price. They allow investors to benefit from price movements without owning the underlying asset.

What is the difference between shares and derivatives?

The difference between shares and derivatives lies in the type of investment. Shares represent ownership in a company and give the holder the right to dividends and to participate in corporate decisions. Derivatives, on the other hand, are contracts based on an underlying asset and reflect the value of that asset. Unlike shares, derivatives do not offer ownership rights but speculate on the future price development of the underlying. Trading derivatives can be used for both speculation and hedging risks.

Is there a recommended holding period for derivatives?

The holding period for derivatives depends heavily on the type of derivative and the investor’s strategy. For options or futures, the holding period may vary according to the contract’s duration, with some held for only days or weeks, while others may last over a longer period. Derivatives such as swaps can often be held for years, as they are specifically tailored to long-term financial strategies. There is no general recommendation, as trading in derivatives is highly dependent on individual market analysis and the investor’s objectives.

What risks do derivatives involve?

Trading in derivatives is associated with significant risks. The use of leverage can result in both high profits and losses. Especially with OTC derivatives (traded over the counter), there is a counterparty risk where one party may fail to meet its obligations. Market risks such as sudden price movements of the underlying asset or unpredictable volatility can also lead to losses. In addition, a lack of regulation in some derivatives can impair market transparency, creating further uncertainty.

How can you buy derivatives?

Derivatives can be purchased through crypto exchanges or traditional financial markets. The most common options are exchange-traded derivatives such as warrants or futures, which are traded on specialised exchanges like EUREX. Alternatively, OTC derivatives can be bought through financial institutions or broker platforms offering individually negotiable contracts. To buy derivatives, investors must open an account with an exchange or broker and complete the necessary verification process to start trading.

Do you have to pay tax on derivatives?

Yes, trading in derivatives is subject to tax regulations in many countries. The tax treatment of derivatives often depends on the type of derivative and the holding period. In Germany, for example, profits from trading derivatives are generally taxable and must be declared in the income tax return. The tax rate depends on the nature of the income (e.g. speculative gains or income from capital investments).

Further topics related to trading

Want to deepen your trading knowledge? In our Bitpanda Academy you’ll learn more important trading strategies and indicators for effective trading. You’ll also discover analytical methods such as technical analysis or chart analysis, which you can combine with tools like volatility indicators or moving averages to make more informed trading decisions.

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