The Basic Types of Derivatives Explained

Many investors are familiar with mutual funds, stocks and bonds to a certain extent. I think a less well understood category of investments are derivatives which get their name because they are “derived from other underlying investments” or because the value of the specific derivative investment fluctuates in value based on changes in value of something else (investment values, interest rates, exchange rates, etc).

ChasingTheMarketsOrRisk.jpgThere are actually only two main types of derivatives: option-based and forward-based. Either type can be traded on a recognized exchange or OTC (Over The Counter). The exchanges are public and provide for standardized, liquid contracts whereas the OTC market is private and allows for much more customization of the individual contracts between parties.

Option Based Derivatives

Option-based derivatives represent the right, but not the obligation, to engage in a transaction within a set period of time. In other words, an option is exactly that: an option. Just because you own an option does not mean you have to make a transaction – rather it is the ability to make a certain transaction if you so desire. Options normally have an upfront cost associated with them known as the “premium” for the contract. They are known as options whether they are traded on an exchange or Over-The-Counter. An example would be a Call or Put option – a Call option represents the right (but not the obligation) to buy a stock for a set price for a certain period of time. A Put option represents the right (but not the obligation) to sell a security at a certain price for a given period of time.

Forward-Based Derivatives

Forwards represent the obligation to make a transaction at a set point in time in the future. Once you enter into a forward-based contract, you are obligated to make the transaction (unless both parties agree to cancel or otherwise modify the agreement which is rare). Unlike an option, there is no up-front cost to entering into a forward-based derivative contract. When a forward contract is traded on a recognized exchange, it is referred to as a “futures contract” or “futures” for short. Examples of futures include commodities, interest rates, currencies, and stock market indices.

When a forward based derivative is traded OTC (Over-The-Counter) it can be referred to as a “forward agreement” or a “forward”. Two specific types of OTC forwards are forwards based on exchange rates, known as “foreign exchange agreements” and forwards based on interest rates, known as “forward rate agreements”.

Another example of a special OTC forward-agreement is the “swap”. Specifically, a swap allows for the swapping of regular cash-flows based on a pre-determined formula. It can be viewed as a number of periodic forward agreements packaged into one agreement as well. A specific type of swap used can be between a bond fund manager and an equity fund manager. They can swap the performance with each other and in effect the equity manager could say that he is running a tax-efficient bond mandate for his investors (as is the case in a capital yield class or managed yield fund where the investor receives fixed-income type risk and returns with the distributions treated as capital gains).  A specific example would be the Mackenzie Sentinel Canadian Managed Yield Class – click here to see the fund profile and then scroll down to the Major Holdings to see that it owns stocks and yet provides fixed-income like returns. (Note the profile explains they use “options” which is not correct, they use “swaps” which are a type of forward-based derivative.)

A Third Main Type of Derivative – CFDs

CFDs – or “Contracts For Differences” are a little different from the above mentioned derivatives. The main difference is that a CFD has no expiration date. CFDs are OTC products and you normally buy and sell them through a CFD provider and are cash-settled as opposed to physically-settled which means you never have to own the underlying investment which can be a commodity, stock market index, individual stocks, currencies, etc. They are normally offered with significant leverage built in to the tune of 100:1 with some CFD providers. 100:1 means that your returns are magnified 100 fold, not 100% – you really need to think twice about playing the CFD markets.

So there you have a very basic primer on the basic types of derivatives out there. One thing in common is that all derivative products basically can magnify risk and returns TREMENDOUSLY. There are however, many different strategies for the application of derivatives – some of which are very conservative strategies and others are “if I get this wrong I’m going to commit suicide” risky. Make sure to seek the counsel of a qualified financial advisor before engaging in derivative investments. Over time, I will write in more detail on some of these specific derivatives and some derivative strategies.

I had written a three-part guest series on the Million Dollar Journey on the Basics of Call Options previously, and you can read the series by clicking here.

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Comments

  1. Derrick Fung says:

    Thanks for this Preet – very useful

  2. Acorn says:

    Hi Preet,
    Could you please explain in more details this:

    "…manager could say that he is running a tax-efficient bond mandate for his investors (as is the case in a capital yield class or managed yield fund where the investor receives fixed-income type risk and returns with the distributions treated as capital gains."

    I’m holding a few T8 funds, which make distributions every month. Although they treat these distributions as ROC, nobody was able to explain me clearly how they calculate these distributions (they are not exactly the same from month to month). Is this something related to your above mentioned comment?

    Thank You

  3. Preet says:

    Hi Acorn, these are two separate issues. The T8 structure you are talking about refers to the annual distribution you receive from your particular fund of 8%. Much of which will be ROC, and some may be either interest, dividends, or realized distributed capital gains.

    The actual yield on your fund might be 3%, and ROC (return of capital) might make up the other 5%. This means they are treating part of the distribution as a return of your original principal. This will slowly grind your ACB (adjusted cost base) down to zero on the portfolio and when that happens, every dollar you receive will be taxable (most will be capital gains, and there will be some interest and dividends).

    Does this answer your question?

    What I was referring to above is separate, although it could also apply to your funds as well – but not necessarily so.

    Your T8 fund means your funds have a ROC series or T-SWP series of units.

    A capital yield class fund is different, and may or may not have a T-SWP series.

    Preet

  4. Acorn says:

    Hi Preet,

    Since I’ve mentioned T8 funds, let me clarify my question… I’ve looked closely at my fund’s account transactions list. What these funds do is that they distribute a monthly DIVIDENT and than, somehow (may be by using a magic powder), they convert these funds into 100% ROC and make payouts to my checking account. They call it as a “tax-efficient distributions”. Interesting, but in the end of the year my tax slip didn’t show any DIVIDENT distributions, only ROC. That’s why I’m wondering how they do that? May be there are other products in the market, which do the same things?

    Thank You.

  5. Preet says:

    Sometimes reporting statements will use the word "dividend" incorrectly, which looks like the case here. If you want, you can send me the name of the fund by email privately and I will confirm it for you.

    I’m willing to venture that a fixed monthly distribution isn’t likely to be dividend income for tax reporting purposes, rather this is the monthly distribution of the fund and in this case it is mostly return of capital.

    Preet