How to use derivatives to manage risk and win trust

Learning the ins and outs of financial markets can feel overwhelming, but understanding the basics of certain financial contracts like derivatives can make a big difference. These are contracts whose value is based on something else, such as a stock, currency, or commodity. 

Derivatives are usually used to manage risk, earn profits, or protect one's investments. While the idea might sound complex, the concept plays a role in global finance. From farmers to hedge funds, many use derivatives daily. 

In this article, Wealth Professional Canada will look at what derivatives are in the context of wealth management. We’ll also discuss common examples and how they can be used by professionals to improve their services and attract more clients. 

What are derivatives in wealth management? 

Derivatives are financial contracts that get their value from something else, often called an “underlying asset.” This asset could be:  

• stock 
• bond 
• commodity 
• interest rate 
• currency 
• market index 

Instead of owning the asset itself, you are trading a contract based on how the asset performs. Derivatives are also commonly used for hedging, speculation, and arbitrage. 

The purpose of a derivative is to let people manage financial risk or speculate on price changes. These contracts are widely used by businesses, investors, banks, and even governments. There are several major types of derivatives. Each works a bit differently, but they share the same idea: their value depends on another financial item. 

Want to better understand how this financial contract works? Watch this clip: 

If you want to dive deeper into what derivatives are, you should already know the basics of trading. As a reminder, trading involves buying and selling different assets with the goal of earning a profit. 

OTC derivatives 

Over-the-counter (OTC) derivatives are contracts traded directly between two parties, outside of formal exchanges. These include many forwards, swaps, and some options. OTC derivatives offer flexibility in terms and structure but come with higher counterparty risk. 

These also have less regulatory oversight compared to exchange-traded derivatives. 

What are examples of derivatives? 

There are four primary types of derivatives. Each type has unique characteristics, benefits, and risks: 

1. Futures 

Futures are standardized contracts traded on exchanges. They require one party to buy, and the other to sell, a specific asset at a set price on a fixed date in the future. These contracts are often used for managing risk or speculating on price movements. 

Futures are common in commodity markets such as oil, wheat, and natural gas. In financial markets, they are also used for indexes, currencies, and interest rates. 

For example, a financial advisor in Canada who wants to protect a portfolio tied to equities might use an S&P/TSX 60. They’ll use a futures contract to help reduce losses during a market downturn. 

2. Options 

Options give the buyer the right, but not the obligation, to buy or sell an asset at a specific price before a certain date. There are two main types of options: 

• call options: allow the buyer to purchase the asset 
• put options: allow the buyer to sell the asset 

This type of derivative is used for both protection and speculation. A common example is when investors buy put options on a stock they already own. This allows them to limit potential losses if the stock drops, while still keeping the chance to gain if the price rises. 

Unlike futures, options give more flexibility since the buyer is not required to go through with the deal. 

To learn more about these futures, options, and other insights about derivatives, watch this video: 

This video lesson is part of chapter 10 of the Canadian Securities Course (CSC). Check out this guide for more info about the CSC and how it can help push your career. 

3. Forward 

The next type of derivative is a private contract between two parties who agree to buy or sell an asset at a future date for a price they set in advance. Forward contracts are not traded on public exchanges and can be customized to meet specific needs. 

Flexibility makes forwards useful in business settings, but they also come with higher counterparty risk because there is no third-party clearinghouse. For instance, a local company expecting to receive revenue in United States dollars, might use a forward contract to lock in an exchange rate. 

This helps the company avoid losing money if the Canadian dollar rises before the payment is received. 

4. Swaps 

Swaps are contracts where two parties agree to exchange financial obligations. These financial contracts are usually used to manage interest rates or currency risks. The two most common types are interest rate swaps and currency swaps. 

In an interest rate swap, one party agrees to pay a fixed interest rate and receive a floating rate, or vice versa. This is often used to get more predictable loan payments. For example, a local business with a loan that has a floating interest rate might use a swap to convert it to a fixed rate. 

This helps the company plan its payments more easily, especially when interest rates are uncertain or rising. 

Canada’s first derivatives business conduct rule implemented 

On September 28, 2024, Canada implemented its first national derivatives business conduct rule, aimed at increasing transparency and protecting investors in the derivatives market. 

The National Instrument 93-101 – Derivatives: Business Conduct, published by the Canadian Securities Administrators (CSA), sets out new standards for how firms and financial advisors must treat clients. 

It also includes requirements for disclosure, conflict management, and suitability assessments. Wealth management professionals who use derivatives must now follow these enhanced standards. 

How derivatives work in a wealth management strategy 

In a wealth management setting, derivatives are often used to reduce volatility or protect a client’s investment. They can also allow for strategic exposure to certain market movements. 

Some clients might use derivatives to generate income through writing covered calls. Others might use interest rate swaps to protect fixed income holdings when rates are rising. 

Here are some of the main ways derivatives are used in portfolio strategy: 

• Hedging against downside risk: Options can be used to lock in a minimum sale price on a stock or index. This can reduce the impact of market corrections. 

• Managing interest rate exposure: Swaps can be used to convert fixed rate payments to floating or vice versa. This helps reduce the impact of changing interest rates. 

• Targeting tactical exposure: Futures can give access to equity or commodity markets without direct ownership. This can allow quick and low-cost exposure. 

• Generating income: Covered call writing is a strategy that can bring in extra yield on top of dividend payments. 

Technology platforms have made it easier to model the impact of derivatives on a portfolio, but understanding the product structure is still needed. Financial advisors should consider a client’s risk profile and investment goals before recommending derivative exposure. 

Why derivatives matter 

Derivatives are used in a variety of settings, like banks, hedge funds, pension plans, and even corporations looking to stabilize their earnings. Let’s look at a few reasons why derivatives matter: 

Risk management 

Although derivatives do not directly involve ownership of the actual asset, they serve many purposes in financial markets. One of their main goals is to manage risks. For example, airlines can use energy derivatives to lock in fuel prices, which protects them from sharp increases in oil costs. 

Speculation 

Derivatives are also used for speculation. Traders might buy or sell derivatives to bet on the future price of an asset, hoping to profit from its movement. While this adds liquidity to markets, it also increases the potential for large losses if markets move in the wrong direction. 

Arbitrage 

In some cases, derivatives can be used for arbitrage. This involves taking advantage of price differences in different markets to earn a profit. A trader might buy an asset in one market and sell a derivative tied to it in another, earning the difference with minimal risk—at least in theory. 

In short, derivatives are central to how modern finance operates. They help stabilize prices, increase efficiency in markets, and provide tools for managing uncertainty. 

Upsides and downsides of derivatives 

Derivatives bring many advantages to financial systems, but they also come with notable dangers. Their impact depends on how and why they are used. Below are some benefits and risks that come with derivatives: 

Upsides of derivatives 

• Hedging against price changes: Derivatives allow companies and investors to protect themselves from unfavorable price movements. A wheat farmer might use a futures contract to lock in a sale price for their crop, protecting their income even if wheat prices fall. 

• Access to markets or strategies not available otherwise: With derivatives, investors can take positions in markets where direct access is difficult or expensive. For example, some investors use index options to gain exposure to an entire stock market without owning every stock in it. 

• Lower capital requirements: Many derivatives require only a small upfront payment known as a margin. This allows investors to control a larger position with less capital. While this increases potential returns, it also increases potential losses. 

• Price discovery: Because derivatives markets often respond quickly to new information, they can help reveal what investors expect future prices to be. This helps businesses and governments make informed decisions. 

• Liquidity: In many cases, derivatives are highly liquid, especially those that are traded on regulated exchanges. This means they can be bought or sold quickly, often at a low cost. 

Downsides of derivatives 

• Leverage can magnify losses: Because only a small amount of money is needed to control a large position, losses from derivatives can be much larger than the original investment. For instance, in the 2008 financial crisis, some banks took too many risks. 

• Counterparty risk: In OTC derivatives, there is always a chance the other party will fail to meet their obligations. If a major institution defaults, the ripple effects can be severe. 

• Market complexity: Derivatives can be difficult to understand, especially for retail investors. This can lead to misuse or unexpected outcomes. For example, a person might think they are limiting risk when they are actually increasing it. 

• Lack of transparency: Some derivatives are not traded on public exchanges, making it hard for regulators or even participants to see the full extent of exposure. This hidden risk can create systemic problems. 

• Legal and operational risks: Errors in contracts, miscommunication, or failure to properly manage and monitor positions can lead to financial loss. In fast-moving markets, even a minor oversight can have major consequences. 

• Correlation breakdown: Derivatives often assume a relationship between two assets. If that relationship breaks down, the derivative might not behave as expected. This risk increases during times of financial stress. 

Despite the risks, derivatives remain a useful tool for managing financial exposure. The challenge lies in understanding how they work and using them wisely. Investors, companies, and regulators will continue to learn from past mistakes and improve safeguards. 

The goal is to keep the benefits of derivatives while limiting the damage they can cause when misused. Overall, derivatives might not be a fit for every client, but they can be a smart addition to the toolbox of a modern wealth advisor. 

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