Derivatives Financial Tools: From Mesopotamian History to Modern Markets

The Development Journey of Derivatives Trading

Not a new concept, derivative financial instruments have existed since ancient Mesopotamia over 2000 years ago in the form of primitive futures contracts. However, it was not until the 1970s that they truly developed rapidly, when financial scientists created revolutionary pricing formulas. Today, no modern financial system can be separated from derivative instruments.

Definition and Core of Derivative Instruments

A derivative financial instrument is essentially a contract whose value depends entirely on the fluctuations of the underlying asset. These underlying assets are highly diverse—from commodities like crude oil, gold, silver, agricultural products to financial tools such as stocks, bonds, market indices, or exchange rates and interest rates.

When the price of the underlying asset changes, the value of the derivative also changes accordingly. Due to this complex nature, valuing derivative financial instruments is always a significant challenge compared to traditional financial tools.

Main Types of Derivative Instruments and Their Unique Features

The derivatives market includes many different types of contracts, each with its own mechanism and characteristics:

(Forward) Contract

• An agreement between two parties to buy or sell a certain amount of the underlying asset at a predetermined price, with the transaction date set in the future
• Settlement occurs exactly at the contract’s end
• No intermediary intervention; both parties do not incur any fees
• Not listed on official exchanges

(Futures) Contract

• A standardized version of the forward contract, listed and traded on official exchanges
• The underlying price changes daily according to market value
• Higher liquidity compared to forward contracts
• Both parties must deposit margin at the exchange to ensure performance
• The contract’s value is revalued daily based on the market

(Options) Contract

• A unique instrument allowing the holder the right (not to be obliged) to buy or sell the underlying asset at a specified price within a certain timeframe
• The most modern derivative instrument officially listed
• Has independent intrinsic value due to its rights nature
• Market price is determined based on the underlying asset’s price

(Swaps) Contract

• A transaction between two parties involving the exchange of a financial cash flow
• Cash flows are calculated based on agreed principles
• Usually traded outside centralized exchanges
• Cannot be traded back like regular securities; it is an independent contract between two parties

Two Main Trading Paths

Over-The-Counter (OTC) Trading (Over-The-Counter) These are derivative contracts executed privately between two parties without strict regulation. The advantage is lower transaction costs due to the absence of third-party involvement. However, the downside is counterparty risk—one party may fail to fulfill the contract at maturity.

State-Regulated Exchange Trading Derivative securities here must undergo a vetting process before being officially listed. Trading on regulated exchanges incurs higher fees, but both parties are assured of their legal rights and obligations.

CFD and Options: The Two Most Popular Instruments

(CFD) (Contract for Difference) An agreement between two parties to settle the difference in the price of an asset from the time the position is opened until it is closed. This is the most common instrument in OTC markets due to its simplicity—direct contract between investor and broker.

Options Provide the right (not to be obliged) to buy or sell an asset at a predetermined price within a specified timeframe. It is the most modern instrument listed on exchanges.

Real-World Comparison:

• CFD: An open-ended contract, can be closed at any time, compatible with over 3000 types of commodities, uses high leverage to reduce capital investment, low transaction costs, prices closely follow the underlying asset
• Options: A contract with a fixed expiration date, can only be closed before or on the expiration date, not all commodities are available, large trading volume results in higher fees, requires complex valuation formulas

Steps to Practice Derivative Trading

Step 1: Choose a Reputable Trading Platform Selecting a reputable platform is the most important step to avoid counterparty risk. Prioritize those regulated by government authorities.

Step 2: Open a Trading Account Complete identity verification procedures and set up an account on the platform.

Step 3: Deposit Margin Transfer margin funds into the account. The amount depends on the desired trading volume and leverage level.

Step 4: Execute Trades Place a buy (Long) order if expecting prices to rise, or a sell (Short) order if expecting prices to fall via the app or web version.

Step 5: Manage Positions Continuously monitor the market, take profits when targets are reached, and cut losses promptly to limit damages.

Real-Life Scenario: Making Money from Gold Price Fluctuations

Imagine gold is currently at a peak ($1683/oz) and based on economic analysis, you predict a sharp decline. Although you do not own physical gold, you decide to leverage a derivative instrument based on gold (CFD gold).

Strategy 1: No Leverage

• Open a Short position at $1683/oz with initial capital $1683
• If the price drops to $1660: profit $23 equivalent to 1.36%
• If the price rises to $1700: loss $17 equivalent to 1%

Strategy 2: Use 1:30 Leverage

• Open a Short position with only $56.10 (1/30 of the price)
• If the price drops to $1660: profit $23 equivalent to 41%
• If the price rises to $1700: loss $17 equivalent to 30%

Leverage significantly increases potential profit percentages but also comes with higher risk of loss.

The Role of Derivative Instruments in Financial Markets

Hedging (Hedging) The original purpose of derivatives was to allow investors to buy an asset with an opposite price movement to offset losses in the underlying asset.

Pricing Underlying Assets The trading price of futures contracts can reflect and approximate the actual commodity prices.

Enhancing Market Efficiency Through derivatives trading, one can replicate the payout levels of assets, helping the prices of underlying assets and related derivatives maintain balance.

Access to New Financial Opportunities Interest rate swaps enable companies to access more favorable interest rates compared to direct borrowing.

Unavoidable Risks

Extreme Price Volatility The complex design of contracts makes valuation extremely difficult, sometimes nearly impossible. High risk is an inherent characteristic of derivatives.

High Speculative Nature Large and unpredictable price fluctuations make derivatives a favorite among speculators. Unreasonable speculation can lead to total capital loss.

Valuation Risks OTC contracts are not subject to vetting, posing the risk that the counterparty may not fulfill the contract.

Who Should Participate in the Derivatives Market?

Commodity Extraction Companies Companies extracting crude oil, gold, or operating in agriculture can use futures contracts to lock in prices and hedge against price volatility.

Investment Funds and Trading Companies They utilize derivatives to leverage, hedge investment portfolios, or optimize asset management strategies.

Individual Traders and Investors Individuals use derivatives to speculate on various assets and can leverage to increase potential profits, though risks also increase proportionally.