FUTURES AND DERIVATIVES

I. Definition of derivative
Derivatives are financial instruments whose value is derived from the value of
something else. They generally take the form of contracts under which the parties
agree to payments between them based upon the value of an underlying asset or
other data at a particular point in time. The main types of derivatives are futures,
forward, option and swap
The main use of derivatives is to minimize risk for one party while offering the
potential for a high return (at increased risk) to another. The diverse range of
potential underlying assets and payoff alternatives leads to a huge range of
derivatives contracts available to be traded in the market. Derivatives can be based
on different types of assets such as traditional security ( such as stocks, bonds),
commodities, interest rates, exchange rates, or indices (such as a stock market index,
consumer price index (!") # see inflation derivatives # or even an index of
weather conditions, or other derivatives). Their performance can determine both the
amount and the timing of the payoffs.
$inancial derivatives have two ma%or roles. These are&
'peculation
(edging
$inancial derivatives are instrumental in the hedging process because through them,
parties can exchange risk. )sually, this is possible through the use of an underlying
asset or a stock that actually exists. The underlying asset gives one party the
opportunity to shield themselves against a potential risk in the future while the other
party also does the same.
Derivatives are also instrumental in the process of hedging because of the fact that
they are *uite simple in themselves and do not re*uire intricate balance sheet
formulations. Derivative products can be set up regardless of the fact that those
products do not actually exist. )sually, in the financial market, derivatives are
obtained from existing marketing indices. This allows an individual or a business
the opportunity of controlling a very large investment with %ust a small investment
(this is usually called the option premium or margin). Through this channel of
investment, traders have the opportunity of hedging themselves against the risk of
actually purchasing the future stock using their actual value.
The second attribute about financial attribute is with regard to their role in
speculation. +esearch shows that large numbers of traders engage in speculative
trading these financial derivatives. ,umerous institutions believe that it can be
possible to establish a trend of how a particular form of security will behave in the
future. "nvestors usually call this kind of investment, directional playing. -esides
that approach, speculation can also be done on the nature of a security.s volatility.
)sually, the latter strategy applies to options as a form of financial derivative.
II. Types of derivative instruments
Derivative contracts are of several types. The most common types are forwards,
futures, options and swap.
1) Forward Contracts
/ forward contract is an agreement between two parties 0 a buyer and a seller to
purchase or sell something at a later date at a price agreed upon today. $orward
contracts, sometimes called forward commitments , are very common in everyone
life. /ny type of contractual agreement that calls for the future purchase of a good or
service at a price agreed upon today and without the right of cancellation is a forward
contract.
2) Future Contracts
/ futures contract is an agreement between two parties 0 a buyer and a seller 0 to
buy or sell something at a future date. The contact trades on a futures exchange and
is sub%ect to a daily settlement procedure. $uture contracts evolved out of forward
contracts and possess many of the same characteristics. )nlike forward contracts,
futures contracts trade on organized exchanges, called future markets. $uture
contacts also differ from forward contacts in that they are sub%ect to a daily
settlement procedure. "n the daily settlement, investors who incur losses pay them
every day to investors who make profits.
3) Options Contracts
1ptions are of two types 0 calls and puts. alls give the buyer the right but not the
obligation to buy a given *uantity of the underlying asset, at a given price on or
before a given future date. !uts give the buyer the right, but not the obligation to sell
a given *uantity of the underlying asset at a given price on or before a given date.
) Swap
'waps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of
forward contracts. The two commonly used swaps are interest rate swaps and
currency swaps.
"nterest rate swaps& These involve swapping only the interest related cash flows
between the parties in the same currency.
urrency swaps& These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than those
in the opposite direction.
III. Forward Contract vs Futures Contract
1) Contract speci!ication
/ futures contract2s specification details (also called& contract specs) include the
type, *uality and *uantity of the underlying asset or commodity, traded months,
limited day, traded hours and other details uni*ue to each product. /ll contract specs
can be found online at the exchange trading the contract.
The underlying assets of futures contracts are agricultural commodities, metals and
minerals, energy, such as oil and coal3"n many cases, the underlying asset to a
futures contract may not be traditional commodities at all 0 that is, for financial
futures the underlying item can be any financial instrument ( also including
currency, bonds, and stocks) they can be also based on intangible assets or
referenced items, such as stock indexes and interest rates.

2) Futures "ar#et e$ists !or t%e !o&&owin' reasons
4 (elp for transactions through time becomes easier. !roduction, consumer and
business decisions become more optimal in futures market. "t allows individuals to
make low4cost contracts *uickly to exchange money in the future
4 5anufacturers and consumers can have the most effective assessment on supply
and demand for goods in the future. $rom there, they can make the best decisions
for production and reserves
4 The uncertainty about future prices is the conditions for successful future contracts
transaction, attracts both speculators and hedgers.
3) Sta#e%o&ders on t%e !uture "ar#et
6.7 ) 'peculators& they accept higher risk to seek higher profits from the
price fluctuations. They can keep the long position or short position or both
positions for the same goods (spread position).
They are two kinds of speculator&
4 position traders& they are often in the position and keep them in a few days,
weeks, or few months. They usually use technical analysis to predict price
movements and prices trends in the future then they will be in the proper
position to seek profit.
4 day traders& they %ust seek profit based on price fluctuations in a single trading
day. They never came home with a position in their hand.
6.8) (edgers& they participate in future transactions to prevent the risk of
unfavorable price movements for them.
6.6) 'peculators en%oy differences& they search for profit by considering
some goods with e*uivalent goods for sale two different prices in two different
markets. they are based on the relationship between the spot price and future prices,
or temporary fluctuations in supply and demand disturbs the price to make a profit
from the difference between the spot price and the future price.
6.9) The ob%ect on the trading floor&
4 $loor traders& they trade futures contracts in futures areas (futures pit)
4 $loor brokers& they help to carry out orders for parties
6.:) The ob%ects involved in the market
4 /ssociated persons4/!s
4 ommodity trading advisers4T/s
4 "ntroducing brokers4"-s
4 ommodity pool operators4!1s
) T%e "ar'in re(uire"ents
To participate in trading futures contracts, traders need to deposit a sum of money to
ensure that the parties comply with the terms of the contract. This amount is called
margin. ;ach trading floor will decide the initial margin re*uirement (initial margin)
to be able to trade there. "nitial margin is the amount of money shall be deposited
into the trading account (also called a margin account) when you want to buy or sell.
This initial margin depends on each trading floor, each commodity, and futures
prices of commodities that are traded in the current and past data.
/fter a while, if the account balance falls to or below the margin maintenance
(maintenance margin) as prescribed, then trader has to transfer money into the
account to put money in their account to reach the initial margin level.
)) Co"parison *etween !utures contracts and !orward
contracts
Futures Forwards
- Future contracts are usually
traded in trading floors
- The partners are determined
randomly
- Futures contracts have clearing
houses that guarantee the
transactions, which drastically
lowers the probability of default
to almost never.
- Futures contracts are marked-
to-market daily, which means that
daily changes are settled day by
day until the end of the contract
- Settlement for futures contracts
can occur over a range of dates
- Only 1- ! of the futures
contracts on market are real
transaction "takes place delivery
between the parties#, the rest
mostly are the payment of profits
and losses between the parties.
- Futures contracts are
standardi$ed contracts, only the
- Forward contracts are traded in OT%
or are simply a contract signed
between the two parties
- The parties know e&actly about their
partners
- Forward contracts are private
agreements, there is always a chance
that a party may default on its side of
the agreement and risk is always
involved
- Settlement of the contract occurs at
the end of the contract
- Forward contracts, on the other
hand, only possess one settlement
date
- 'ost forward contracts deliver
commodity between the parties.
Forward markets are poor li(uidity
e&cept forward markets of interest
rate and foreign currency
- )ll terms of the forward contract
may be agreed, negotiated between
the two sides
price is agreed. There is no
negotiation between the two
parties involved in the contract
< E$a"p&e+
, E$a"p&e o! t%e Forward Contract+
/l2s "ce ream buys 5ilk from Tim2s Diary to make an ice cream. The price is
usually 8= >?allon. Tim2s Diary intends to increase the number of cow doubles in
order to produce more and more milk but they predict that the extra milk will put the
price down below 8=>gallon. -efore they carry out their plan, a contract is proposed
to negotiate themselves terms and conditions in which Tim2s Diary will supply their
products to /l2s "ce cream at the fixed price of 8=>gallon in the future (maybe next
six months) despite of milk price volatility. "f this contract is signed by both parties,
a forward contract will be established. /nd the supplier will avoid losing money or
decreasing their profit in future. 1n the other hand, if the milk price suddenly
increases up to 9=>gallon, the supplier must implement their contract and suffer their
losses.
, E$a"p&e o! t%e Future Contract+
"f Tim2s Diary trades with /l2s "ce ream (or another buyer) for milk via the
exchange markets which act as intermediaries, they have to sign a contract which is
standardized, only the price which is 8=>gallon is agreed. The exchange re*uires
both parties to put up an initial amount of cash, the margin. /dditionally, since the
futures price of Tim2s Diary milk will generally change daily, for example, if the
price increases (9=>gallon), the exchange will draw money out of /l2s "ce ream
margin account and put it into the Tim2s Diary and vice versa with the price below
8=>gallon, so that each party has the appropriate daily loss or profit. "f the margin
account goes below a certain value, then a margin call is made and the account
owner must replenish the margin account. This process is known as marking to
market. Thus on the delivery date, the amount exchanged is not the specified price
on the contract but the spot value (since any gain or loss has already been
previously settled by marking to market).
,Su""ar-+ t%e di!!erence *etween 2 a*o.e e$a"p&es+
$orward ontract $utures ontract
The agreed price @es @es
/ specific future date
(Delivery date)
@es @es
"ntermediary (;xchange
markets)
,o @es
5argin ,o @es
Daily loss or profit ,o @es
ontract ,egotiated 'tandardized
!artners Anew exactly Determined randomly
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