How do Traditional Derivatives Work?

Let’s start with a general introduction to derivatives in traditional markets.

Derivatives are financial instruments such as futures, forwards, options and swaps. Derivatives are all forms of contract that represent promises or opportunities to undertake a transaction at some time later than today. They are called ‘derivatives’ because each contract, while it relates to some ‘underlying’ transaction will have a value in its own right – as such a derivative contract derives its price and value from some other thing. That other ‘thing’, referred to in derivative markets as the ‘underlying’, could be a commodity such as wheat, wool, coffee or oil, a precious metal such as gold or silver, a financial asset like a bond or a company share (common stock), a currency, or something as abstract as a share price index like the Dow Jones Industrial Average. Derivatives can even be built on top of other derivatives to create new types of financial instruments, for example options on futures.

The four main classes of derivative contract can be described as follows:

Forward contracts

A forward contract represents a firm commitment to buy or sell an asset at a predetermined price at an agreed future date. Forward contracts are typically traded in the Over the Counter (OTC) markets directly between buyer and seller and as such can be customised for quantity and quality of the underlying asset, and the contract maturity date. Because forward contracts are customisable for the needs of a particular buyer and seller, there is sometimes not a ready secondary market for a particular forward contract (it would require finding a buyer or seller that has exactly the same need as you). Forward contracts are usually settled (completed) by physical delivery and payment for the underlying asset. Forward contracts also carry the full weight of counterparty risk for both buyer and seller.

Futures contracts

Futures contracts are very much like forward contracts in that they represent a firm commitment to buy or sell an asset at a predetermined price at an agreed future date. The difference between forwards and futures is that futures contracts are traded on centralised exchanges (eg the Chicago Mercantile Exchange (CME) in the USA, the ASX in Australia). A feature of exchange-traded futures is that contracts are standardised for quantity, quality or ‘grade’ of the underlying asset, contract maturity date and settlement terms. As such, secondary market trading is much easier via the exchange. Futures contracts are usually also ‘delivered’ by monetary settlement and the counterparty risk between buyer and seller is managed by the exchange.

Options

Options are fundamentally like forwards and futures in that they are contracts about buying and selling an underlying asset at a predetermined price and time, but where they differ is while forwards and futures represent an obligation to buy or sell something, options introduce the element of choice. A ‘call’ option carries the right, but not the obligation, to buy the underlying asset on the specified terms. A ‘put’ option carries the right, but not the obligation, to sell the underlying asset on the specified terms. The holder of an option would only exercise their right to buy or sell under the option if it were financially advantageous (profitable) to do so. Options come in many forms varying from simple to very complex, and there are OTC as well as exchange-traded variants.

Swaps

Where forwards, futures, and options typically relate to a single transaction at a single point in time, swaps are more complex arrangements in that they are typically agreements to undertake a series of transactions over a period of time. Interest rate swaps are a relatively simple form of swap, in which two parties agree to swap fixed interest payments for floating interest rate payments at an agreed frequency for an agreed term. Other types of swaps include currency swaps, debt-for-equity swaps, and credit default swaps, among many others. Because they are most often designed to suit two specific counterparties, most swaps are created and traded on OTC markets.

The size and purpose of the market

The total size of the derivative market is many times larger than the underlying financial assets on which they are built, with some estimates of the total size of the derivatives market at more than US$ 1 quadrillion. The “real” number is likely to be much smaller because derivatives are often netted against each other to manage risk. Nevertheless, derivatives are important types of financial instruments and markets.

While derivatives, especially the exchange-traded ones, can be bought and sold for speculative purposes, most are fundamentally designed to manage the price risk related to the underlying commodity or asset (ie the risk that price of the underlying might move unfavourably to us between now and the future)

To illustrate

Consider the example of a rice farmer who just invested all their money in planting and cultivating rice that will be ready for sale in six months. The farmer is concerned that there might be an oversupply of rice, and therefore lower market prices, at harvest time in six months. The current price of rice is US$120/tonne and the farmer estimates they will harvest one tonne of rice. To hedge against the risk that the price of rice will fall, the farmer can sell a futures contract to lock in the current sale price of US$120 for a sale in six months’ time. The buyer of the futures contract must believe that the price of rice will actually be higher than US$120 in six months. That buyer might be a sushi restaurant that wants to hedge against a price increase, or a speculator that wants to bet that the price of rice will increase.

Suppose that in six months, the market price of rice has fallen to US$110. The buyer of the futures contract must now pay the farmer US$120 at a loss of US$10. In most cases, futures contracts are cash-settled where only the net value of the contract is exchanged (although some can be settled physically) – if the buyer actually wants to receive physical rice, they then go to the physical (spot) market to buy their rice at the prevailing spot price. In this case, the purchaser of the contract pays US$10 to the farmer who uses that to offset having to sell his rice into the market at US$110. In either case, the farmer receives US$120 in value at the end of the futures contract period.

This simple example illustrates that futures contracts are derivatives contracts that reallocate the price risk of an underlying asset across buyers and sellers.