Futures and derivatives are financial instruments that are used by companies and individuals to hedge risk. The risks may be anything that may carry an eventual financial liability and ranges from commodity prices to future revenues or catastrophic insurance losses. These risks are transferred to financially stronger companies or dealers who trade them on to make a profit. The main differences between futures and derivatives are in their regulation.
Two parties agree in a futures contract to buy a tangible or intangible product or asset at a specified price and on a specified future date. The traded asset is called the underlying and may be a commodity, currency, interest rate, stock market index or catastrophic insurance loss. The trade date is called the settlement or maturity date. The agreed price is called the futures price. Both parties are obligated to carry out the contract.
Derivatives are contracts whose value derives from something else. It can be the variation over time of a commodity price, exchange rate, stock market index or bank deposit. It also could be the variation of a commodity price against a stock market index. Technically speaking, a futures contract is a derivative. An option is a derivative contract where a seller offers a buyer the right, but not an obligation as in the case of futures, to buy an asset. They specify both the price, the strike price and the date, the exercise date, of the transaction. A swap is a derivative contract where two parties exchange cash flows, such as interest rate payments. The interest rate calculations are agreed and the two sides are obligated to the deal. There are also combinations of swaps and options called "swaptions."
Futures contracts are also called exchange-traded derivatives because of the location where they are traded. This is the main difference between them and other derivatives. For example, gold or platinum futures are traded on futures exchanges like the Chicago Mercantile Exchange or the London Metal Exchange. The trades are conducted electronically, via telephone or by open outcry. The exchange’s clearinghouse collects payments every business day and settles trading accounts. In this way, the exchange minimizes the credit and counterparty risk and guarantees the financial integrity of the transaction. In effect, the exchange is the counterparty to all trades.
Options, swaps, swaptions and other derivatives that are traded through private agreements between two parties are called over-the-counter derivatives. There is no clearinghouse and the parties assess, or should assess, each other’s credit worthiness. A forward contract is a futures contract that is agreed privately between the parties and traded OTC.
The futures exchanges standardize futures contracts. They define the underlying product or asset and whether it will be delivered in cash or physical kind. The underlying’s grades that could contribute to price fluctuations – such as different qualities of crude oil – are defined, as are the maximum price fluctuations on a trading day. The exchanges also set margin requirements that are financial guarantees to ensure the contract obligations are fulfilled. There is no standardization of, or margin requirement for, OTC contracts.
Futures exchanges, like stock exchanges, are subject to financial regulation. OTC trading accounts for 95 percent of all derivatives trading and is unregulated. This lack of regulation, and the inability of OTC traders to accurately assess their credit risk exposure, led to worldwide popular perceptions that OTC trading was a principal cause of the 2007/2008 financial crisis. Both the U.S. and the European Union adopted primary legislation in 2010 that aimed to introduce a clearinghouse, a central data repository and margin rules for OTC transactions to increase transparency of the OTC deals and reduce counterparty and credit risks.
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