CONTENTS
- 1. Derivatives | Definition
- 2. Derivatives | Understanding Underlying Assets
- - Definition of Underlying Assets
- - The Role and Importance of Underlying Assets
- 3. Derivatives | Types of Contract
- - Forwards
- - Futures
- - Options
- - Swaps
- - Other Similar Contracts
- 4. Derivatives | Types
- - Exchange-Traded Derivatives
- - Over-the-Counter Derivatives
- 5. Derivatives | Nature and Function
- - Key Functions of the Derivatives Market
- 6. Derivatives | Legal Support
1. Derivatives | Definition
A derivative is a financial instrument whose price moves with changes in the value of an underlying asset.
When an underlying asset such as a stock, bond, or commodity exists, the value of the derivative shifts as the price of that asset shifts.
Put simply, a derivative is an instrument whose value follows the price movements of another asset.
2. Derivatives | Understanding Underlying Assets
A derivative draws its value from changes in the value of the underlying asset.
To understand derivatives, then, you first need a clear grasp of what an underlying asset is and the forms it can take.
Definition of Underlying Assets
Under Article 4(10) of the ‘Financial Investment Services and Capital Markets Act,’ an underlying asset is an asset or risk factor that falls within any of the following categories.
▶ Financial Investment Instruments
▶ Currencies
▶ General Commodities
▶ Credit Risk
▶ Natural, Environmental, and Economic Risks
The Role and Importance of Underlying Assets
Because the underlying asset is the basis for calculating a derivative’s value, changes in its price or condition feed directly into the rights and obligations under the derivative.
For example, with an option written on a stock, the value of the option moves as the price of that stock rises or falls.
3. Derivatives | Types of Contract
A derivative is a financial contract that creates future rights and obligations tied to an underlying asset or its value, and the principal forms are forward contracts, futures contracts, option contracts, and swap contracts.
Forwards
Under a forward contract, the parties agree to deliver, at a set future date, an underlying asset or an amount of money calculated by reference to its value.
The terms are not standardized, and details such as the delivery date and the contract amount are settled through individual negotiation between the parties.
The parties generally agree to buy or sell a commodity or financial asset at a price fixed in advance, and a defining feature is that no separate institution guarantees settlement.
Futures
A futures contract is a standardized agreement under which the parties commit to buy or sell an underlying asset at a price fixed in advance for a set future date.
Unlike a forward contract, it trades on an exchange under standardized terms, and a clearing house guarantees settlement.
Futures contracts are useful for hedging price fluctuation risk and span a range of underlying assets, including bonds, foreign exchange, and stocks.
Options
An option contract grants the right to buy or sell an underlying asset on specified conditions at a future point.
The option buyer chooses whether to exercise the right, while the option seller is bound to honor the buyer’s choice.
The principal types are call options, which carry the right to buy, and put options, which carry the right to sell.
Swaps
A swap contract is an agreement under which two parties exchange different cash flows over a defined period.
Common forms include interest rate swaps and currency swaps, in which the parties trade different interest rates or currencies over a defined period to manage risk or meet investment objectives.
Other Similar Contracts
Contracts whose structure closely resembles the forms described above also count as derivatives.
These contracts give rise to rights and obligations driven by changes in the value of an underlying asset, and in legal terms they operate much like a contract of sale.
4. Derivatives | Types
Derivatives fall broadly into exchange-traded derivatives and over-the-counter derivatives, sorted by how and where they trade.
This classification rests on the ‘Financial Investment Services and Capital Markets Act.’
Exchange-Traded Derivatives
An exchange-traded derivative is a derivative that falls within any of the following categories.
▶ Derivatives Traded on a Derivatives Market (Exchange)
▶ Overseas Derivatives Markets
▶ Derivatives Traded According to Standards Set by the Operator of Another Financial Investment Instruments Market
Thanks to the exchange’s systematic management and clearing system, exchange-traded derivatives tend to carry low counterparty risk (that is, the risk of default), and investor protection mechanisms are relatively strong.
Over-the-Counter Derivatives
An over-the-counter derivative is any derivative that does not fall within the exchange-traded category described above.
In other words, it is derivatives trading carried out through direct negotiation and contracts between the parties rather than on an exchange.
Over-the-counter derivatives can be tailored freely, but counterparty risk runs high, and guarantees of performance may be absent.
For that reason, the counterparty’s creditworthiness and the terms of the contract warrant close review.
5. Derivatives | Nature and Function
The derivatives market began as a financial market built for participants who wanted to hedge price fluctuation risk.
In recent years, alongside that hedging function, its role as an investment vehicle has grown steadily more prominent.
Korea’s KOSPI 200 futures and options market is often viewed as a high-return investment vehicle, but at its core its primary purpose is to let investors who hold stocks manage the risk of stock price swings.
Key Functions of the Derivatives Market
1. Risk Transfer Function
Hedgers cut their exposure by passing price fluctuation risk to speculators through the market, while speculators pursue returns in exchange for shouldering that risk.
2. Price Discovery Function
In this way, the market discovers prices efficiently and supplies useful information to investors.
3. Capital Formation Function
In the process, speculators’ funds are put to efficient use, and the fund management of hedgers and the stable operation of businesses are supported, which contributes to capital formation.
4. Enhancement of Resource Allocation Efficiency
6. Derivatives | Legal Support
Derivatives transactions carry complex structures and a tangle of overlapping legal issues, which makes it hard to manage and respond to every risk on one’s own.
The contract formation process, disputes that may surface on exchanges and in over-the-counter markets, and questions about how the governing legal provisions should be read are difficult to handle well without specialized legal knowledge.
For these reasons, the support of an attorney who can give prompt and accurate legal advice on derivatives-related disputes, contract review, and risk management carries real weight.
This firm includes 🔗financial law attorneys who have handled many derivatives-related cases, and it works alongside professionals holding specialized qualifications in their respective fields, including investment asset managers, wealth managers, tax accountants, and certified public accountants.
On that basis, across a range of financial transactions involving derivatives, the firm examines the legal issues in complex derivatives deals from several angles and proposes solutions.
If you need structured legal support on the legal risks that can arise in derivatives transactions, you are welcome to request a consultation at any time.
