Digital Derivatives, Their Types and Specifics of Their Use

Blockchain has already created new ways of managing businesses. Now, its constant development can lead to the complete disruption of traditional finance. We can observe how it starts when a new spot for digital asset products appears, such as cryptocurrencies and stablecoins. Their development led to the rapid growth of the digital-based derivatives market. 

Derivatives are financial contracts between two or more parties that derive their value from an underlying asset. Derivatives can be securities, bonds, currencies, etc., and they can have equivalents in digital assets in the future. 

Derivatives are used for a number of cases:

Risk management and hedging - parties can set a derivative contract to mitigate the impact of asset volatility on the investment.

Leverage exposure - when parties want to profit from the asset volatility without investing too much in the underlying asset.

Access to market - parties may want to access the market without purchasing an asset. To do so, such assets as non-deliverable forwards (NDFs) and contracts for difference (CFD) are used.

Underlying Assets for Derivatives

Based on the underlying asset, we distinguish several derivatives.

Interest rate derivatives

Source: https://www.wallstreetmojo.com/interest-rate-derivatives/ 

An interest rate derivative is a financial instrument whose value is linked to the interest rate movements. These derivatives are frequently used to hedge against the interest rate risk, or to speculate on the future movements of the interest rate. 

Interest rate derivatives vary from very simple to very complex ones. The most common interest rate derivatives are interest rate swaps, collars, caps and floors, and futures. 

Credit derivatives

Credit derivatives are contracts that allow parties to minimize or increase the exposure to risks connected with credit. 

Such derivatives are traded between two parties in a creditor/debtor relationship. These derivatives allow a creditor to transfer some or all credit-related risks to a third party, which accepts these risks in return for a payment.

The following credit derivatives are among the most typical ones:

• Credit default swaps
• Total return swaps
• Collateralized debt obligations
• Credit spread options/forwards

Foreign exchange (FX) derivatives

Source: Forbes 

These are derivatives whose payoff depends on the exchange rate of two or multiple currencies. An FX derivative is a contract that obliges a party to buy or sell a currency at a specific time in the future. 

There are three main types of FX derivatives: 

• Forwards 
• Futures 
• Options
• FX swaps

Commodity derivatives

The underlying value of such derivatives is based on a commodity. It can be gas, agricultural products, metals, minerals, and so on. 

These derivatives allow investors to benefit from a certain commodity without purchasing it. The buyer pays a small part of the commodity value; this part is known as a margin price. With it, the buyer purchases a right to buy the commodity at a specific time in the future at a pre-agreed price. 

The most common commodity derivatives are:

• Forwards
• Futures 
• Options

Equity Derivatives

Equity derivatives are financial instruments whose value is derived from the price movements of the underlying asset. This underlying asset can be a stock or a stock index.

Investors use these types of derivatives to hedge the risks connected with taking short or long positions in stocks. In such a case, a derivative performs the role of insurance. The investor pays the cost of a derivative contract and if he wants to protect himself from a loss in the equity value, he can purchase a put option. If on the contrary, he wants to hedge against the upward move in the equity value, he purchases a call option.

They also can use these instruments to speculate on the asset price movement. 

The most common equity derivatives are:

• Forwards
• Futures
• Options
• Warrants
• Swaps

Digital Derivatives, Non-Transferable Assets, and Why Buying Derivatives Is More Profitable Than Buying an Asset

The digital derivatives that are currently conquering the market resemble commodity or equity derivatives. However, it is important to understand that the majority of digital asset derivative products are non-deliverable. It means that money is exchanged depending on the price movement of an asset, but the asset is not exchanged. 

For example, you can buy 100 shares for $10 each. It will cost you $1,000. In this case, the asset is transferred to you.

Or, you can buy a call option with a $10 strike price. It will cost you less, say, $0.50. The option controls 100 shares, so 0.50 x 100 = $50. The asset is not transferred to you. 

If the shares move to $11 each one, the option will cost not $0.50 but $1, and thus, you double your funds invested in the option. 

If you had purchased the shares instead of an option, after the increase, their total value would be $1,100. You gain $100, which is 10% only.

So, the gain of a trader who purchased the option is significantly higher than the gain of those who bought shares. 

Bottom Line

Digital derivatives offer traders many more opportunities than trading with assets only. These financial instruments are crucial to the development of a digital asset market. They can effectively compete with traditional financial systems and provide traders with advanced tools to protect themselves from losses.