Futures
Futures contracts or simply futures are derivative financial instruments whose value is derived from the value of underlying. The buyer of the futures contract agrees to buy the specific amount of the underlying asset at a predetermined future time and at a predetermined price. The seller agrees to sell and if specified deliver the underlying. Underlying can be any instrument from commodity, currency, stock, bond…
Futures are mainly used for hedging risk against adverse price movements. The trader could also use them to speculate. They are traded on an exchange and thus are standardized. Futures price can differ from the future spot price of the underlying derivative. Traders lock in the price of the underlying using this contract. For example, a farmer can enter a future contract if he fears the price will drop by the expiration date.
Most of the futures are cash-settled meaning there is no physical delivery of the underlying. It also implies the futures market can be larger than the actual market for the underlying asset in question. If a trader goes long and buys the futures he expects the price of the underlying to rise thus he can sell it at that price in the future and thus make a profit. Similarly, the trader can short a contract, speculating that the price will go further down and buy it at a lower price.
If the price of an underlying derivative for future delivery is higher than the spot price it is said to be in contango. Another way round, where the price for future delivery is lower than the spot price it’s known as backwardation.
In trading futures, investors can use leverage. They also must post a margin in order to minimize credit risk. It represents a good-faith deposit held to cover the day-to-day obligations of maintaining the position. Being traded on regulated exchange, the counterparty risk is also reduced as a clearinghouse stands in between. The clearinghouse is the buyer to each seller and the seller to each buyer. In the event of a default, the clearer bears the risk of loss.
Forwards
Forward contracts, or forwards, are derivative financial instruments in which parties agree to transact a specific amount of an underlying derivative at a predetermined future date and price. Forward contracts are not standardized, unlike futures. They are over the counter (OTC) instruments meaning the contract are customized in terms of the underlying derivative, delivery date, size of the contract and alike.
The difference from futures is also that there is no clearinghouse standing between the parties which significantly increases the default risk. Parties are also not required to post margins, but some form of collateral can be agreed upon in the contract. The OTC market is also hard to measure as they are many contracts out of the official records.
Just like the futures, traders use forwards to hedge the risk or speculate on the price direction.
Options
Options contracts are derivative financial instruments that give the holder or buyer the right but not the obligation to buy an underlying asset at a specific price, the strike, on or before the expiry date. The seller of the option is obligated to sell the underlying whether the holder decides to exercise it. The buyer of the option pays the premium for that right to the seller, the writer of the option.
Call options give a right to the buyer but not an obligation to buy the underlying and the seller has the obligation to sell it. Buyers of the call options are bullish on the price as they will exercise the option in case the spot price is higher than the strike. Whether he decides not to exercise it, the loss amount to the premium paid to the seller.
Put options give the buyer the right but not the obligation to sell the underlying at a strike, before or on the expiration date. Buyers of the put options are bearish on the price since they will exercise it if the spot price drops below the strike.
American options give the possibility to exercise the option before the expiry date, while the European options can be exercised only on the expiry date. Options can be both traded OTC and on an options exchange depending on the underlying.
Swaps
Swaps are also derivative financial instruments in which parties exchange cash flows of some financial instruments. The cash flows are calculated over a notional principal amount. Unlike futures, forwards and options, the notional amount is usually not exchanged between counterparties.
Each stream of cash flow represents one leg of the swap. The most common is interest rate swap in which one party pays fixed and the other a variable interest rate. The swaps are arranged between businesses and banks OTC based on their interests and needs. Also, they would act through an intermediary like a bank.
Among the widely used instruments are credit default swaps (CDS) which guarantee to cover the principal and interest of a loan in exchange for a premium paid from a buyer of the swap. CDS acts like insurance against the default.
The first public swap was in 1981 and between IBM and the World Bank. Today, swaps are among the most heavily traded financial contracts in the world. The Bank for International Settlements (BIS) publishes statistics on the notional amounts outstanding in the OTC derivatives market.
