A derivative is a contract or financial instrument that derives its value from an underlying asset, such as a stock, bond, currency, index or commodity. Many types of derivatives are available for trading, and a futures contract is one example. Other types of derivatives include options, swaps, forwards, warrants and convertible securities. The difference between derivatives and shares is that shares are priced due to supply and demand, whereas the price of derivatives stems from the price of the underlying asset.
A futures contract isn’t different from a derivative – it is a type of derivative.
Primer on Derivatives
Derivatives can trade as standardized contracts on regulated exchanges, or as unique contracts that trade privately (i.e., “over the counter”) between counterparties. A familiar example is the standardized options market, where highly regulated options trade on various exchanges such as the Chicago Board Options Exchange and the New York Stock Exchange American.
Convertible securities typically trade on stock and bond exchanges, and you can trade futures on the New York Board of Trade, the CBOE Futures and many other futures exchanges. On the other hand, swaps are derivatives that usually trade over the counter, although a few types of swaps are standardized and exchange-traded.
Types of Derivatives
The roster of financial derivatives includes the following:
- Futures contract: Standardized, exchange-traded future derivative contracts that specify the transfer of the underlying asset for a specified price on a set date at a specified location. The quantity and quality of the underlying asset are completely described by a standard futures contract.
- Forward contract: An over-the-counter version of a futures contract in which the terms are privately negotiated by the buyer and seller (i.e., the counterparties).
- Option: A contract that permits, but does not require, the buyer (the long position) to purchase a set amount of the underlying asset from the writer (the short position) at a set price (the strike price) on or before the expiration date. Options typically trade on exchanges.
- Warrant: An option-like derivative with a long-dated expiration. Companies often bundle warrants with other securities at the time of issue.
- Swap: A contract to exchange cash flows between two different assets. The exchange can occur periodically (on reset dates) until the expiration date. Most swaps trade over the counter, but some types are standardized and trade on exchanges. A credit default swap is a type of financial insurance in which the seller pays the buyer a specified amount if the underlying loan defaults or is downrated.
- Convertible security: Bonds and preferred stock that include an option for the buyer to convert the security to another one, usually common stock. These are hybrids of derivative and underlying instruments, since pricing is based on the securities' intrinsic value and the value of the conversion option.
- Asset-backed security: A security that is backed by a pool of assets. This category includes mortgage-backed securities and collateralized debt obligations. ABS are over-the-counter securities issued by banks, government-sponsored enterprises and private issuers.
Characteristics of Derivatives
Despite the wide variety of derivatives, they share certain characteristics that include:
- Underlying asset: A derivative is linked to one or more underlying assets. The type of underlying asset largely determines the behavior of the derivative. For example, an XYZ stock option is linked to the underlying asset, 100 shares of XYZ common stock.
- Expiration date: Most derivatives expire on a certain date. On the expiration date, the derivative might have no value, and the buyer takes a loss. Otherwise, the terms of the contract are executed, and an exchange of assets (including cash) occurs.
- Time value: The value assigned to an option beyond its intrinsic value (i.e., the value of the option if it expired today). Time value decreases as the expiration date approaches, at which point the time value is zero. Time value stems from the volatility of the underlying asset. In a nutshell, a derivative with a distant expiration date is more likely to have price fluctuations that benefit the buyer, so it has more time value.
- Reference price: Many derivatives reference a particular price that helps determine the contract’s value. For example, an option’s strike price refers to a price of the underlying asset that helps determine the option’s value.
- Risk: Derivatives carry several types of risk, but the basic one is market risk – the chances that the derivative will lose value when market prices change. Options and other derivatives offer leverage, which means you can use debt to control the underlying asset without paying the full price for that asset; leverage magnifies the riskiness of derivatives, since a small percentage price move in the underlying asset can create a large percentage price movement in the derivative. Hedging is the practice of using derivatives to bet against your position in an underlying security, thereby reducing your overall risk. Expiration is another source of risk, because you may not get the price movement you need fast enough to benefit from it. Performance risk (i.e., the risk that one counterparty will not meet its obligations) occurs with over-the-counter derivatives, but exchanges assume performance risk for the derivatives it trades.
- Return: Derivatives can magnify your return the same way they magnify your risk – through leverage. Some derivatives are mildly levered and provide the same magnitude return as their underlying assets. For example, convertible bond prices can move in tandem with the price of their underlying stocks. Other derivatives, like options, may provide relatively high returns on a percentage basis. For example, you might have a stock option that doubles in value when the underlying stock price changes by a single dollar.
- Correlation: Correlation pertains to the interconnection between the price of a derivative and its underlying asset. Call options positively correlate to their underlying assets since they gain and lose value in tandem with these assets. Put options are anti-correlated – they move against their underlying assets. Correlation also pertains to the contents of your portfolio. The more diversified your portfolio, the less the correlation among the assets. This lowers the risk that any one asset will cause major damage. You can diversify your portfolio inexpensively by investing in derivatives, since their relatively low prices allow you to control a wide variety of assets.
Understanding Futures Contracts
Futures contracts are available for many types of underlying assets, including commodities, currencies, indexes, debt and equity. Many futures contracts are physically settled, meaning that the seller must deliver the specified quantity and quality of underlying asset to the buyer after contract expiration (on the delivery date), at the delivery location. In return, the buyer must pay the contract-specified amount, a process mediated by the futures exchange.
Alternatively, a futures contract can be financially settled. These operate the same as physically-settled contracts, except no delivery occurs.
Margin on Futures
When you buy or sell a futures contract, you put up a percentage of the contract value in cash deposited to your brokerage account to secure your performance obligations. This is called the margin requirement, and each contract specifies both the initial and maintenance margin amounts. Your broker must be a member of the futures exchange and is responsible for maintaining a sufficient account balance to satisfy margin requirements. The exchange ensures that brokers enforce the rules.
Daily Cash Settlement
The futures exchange is the counterparty to every futures trade. It acts as the buyer for sellers and seller for buyers. In this way, it assumes counterparty risk and guarantees contract performance. The primary way it mitigates this risk is through daily cash settlement, in which each contract is marked-to-market. That is, the daily change in contract value is evaluated, and money is transferred from the loss positions to the gain positions.
For example, if a futures contract on gold decreases in value by $50 during the day, the exchange collects $50/contract from the margin deposited in the brokerage accounts of long positions and transfers the money to the accounts of traders with short positions.
A margin call will occur when a trader’s margin balance falls below the exchange’s maintenance margin requirement. When this occurs, the trader has a few days to replenish the account, or else the exchange will close out the trader’s position and assume responsibility for fulfilling the contract. For example, the COMEX 100 gold futures contract has a maintenance margin requirement of $3,400. If a trader fails to maintain at least $3,400 per contract in the brokerage account, the exchange will issue a margin call.
Futures Vs. Forwards
The effect of marking to market is that daily gains and losses are immediately settled, preventing a large debt from building up over time. When comparing futures vs. forwards, note that forward contracts do not have daily mark-to-market provisions unless specifically negotiated in the contract. The counterparties to a forward contract must rely on each other to fulfill their obligations, as there is no exchange to guarantee performance.
Closing Out a Futures Contract
A futures contract automatically closes on the expiration date. If the contract is physically settled, then the underlying asset is exchanged for cash on the delivery date, some time after expiration. On the other hand, if the contract is financially settled, no further action occurs after expiration.
If a counterparty wants to close out her futures position before expiration, she offsets her position. If long, she sells an identical contract, and if short, she purchases an identical one. After one last daily settlement, the trader is no longer a counterparty to the contract.
Traders and the Closing Process
In the futures market, speculators are traders who do not wish to take physical delivery of the underlying assets and with a goal to profit from favorable price movements of the underlying asset. Because they participate using margin, they maintain levered positions, which allows them to control more contracts than they could if they paid full cash for each contract. Speculators favor financially-settled futures contracts, but if they trade a physically-settled contract, they close out their positions before expiration.
The futures market also encompasses participants who do wish to take or make physical delivery of the underlying asset at a known price. For example, a wheat farmer can nail down the sale price of his crop well before harvest, thereby eliminating uncertainty about his sale proceeds. The counterparty might be a grain processor who also benefits from knowing how much he will have to spend to acquire the harvested wheat.
Hedgers are traders who want to protect another position from loss, such as an oil driller who benefits when oil prices rise but loses when prices fall. The driller can sell crude oil futures to hedge some or all its natural long position. As the contract seller, the driller gains whenever prices fall, thereby helping to offset losses in its oil asset. By adjusting the number of contracts he sells, the driller controls how much price risk he hedges.
The Importance of Derivatives
Futures and other types of derivatives are important financial vehicles, because they facilitate commerce and allow market participants to shed or assume risk. This encourages increased participation in the asset’s market, since traders can enter the market while controlling their risk. Most derivatives provide leverage that helps participants achieve their goals with less money. In addition, derivatives often predict the future price of the underlying asset, thereby guiding economic activity.