What Is a Flow Derivative?

A flow derivative is a special type of securitized derivative that uses the process of maximum leveraging to potentially make very large financial gains with small movements in a market's value. Unlike other derivatives that can be based on anything from rice futures to exchange traded funds (ETFs), the flow derivative is based on the movement of value in the trading of currencies tied to a set of assets. The market for the international electronic trading of currency is known as the Foreign Exchange Market (FOREX). There are several different types of flow derivative financial instruments, including the vanilla option, the barrier option or WAVE, and others. All flow derivative instruments are set to rising or falling values in exchange rate fluctuations for currencies.

The currency trading platform for the flow derivative is a fast moving one, as the derivatives are traded in real time. Normally an investor in traditional stock who puts in a buy or sell order must wait a certain amount of time before the order is filled, depending on the volume of trading and other factors. With a flow derivative, the order is placed automatically and speculators take positions on rising or falling values with the financial instrument.

A spot position with a flow derivative is an agreement between a buyer and a seller where one currency is matched against another and a specific date for the trade is set. Spot positions as of 2010 were popular enough to account for over one-third of all trading taking place on FOREX. Spot positions are always set to take place two days after the agreement is reached, except for a handful of currencies like the US dollar and Russian ruble which trade the very next business day.

Forwards are another type of flow derivative position. These instruments have open-ended dates that the trading parties themselves set, which can be from days to years down the road. Once the date is set, the transaction is completed on that date regardless of how the currency values have changed in the interim.

Option trading positions are another type of speculation on the currency exchange. The owners of options are not obligated to actually trade them on the preset date, which is from where the term originates. Since options are more flexible than other types of flow derivatives, they account for the bulk of trading on the FOREX exchange and involve far more liquidity for the movement of cash assets.