When most people think about investing, the investable assets that come to mind are stocks and bonds. However, an increasingly large proportion of investment markets are dedicated to financial instruments known as derivatives. This series will describe common types of derivatives and discuss how they are generally used by investors and financial institutions. In this post, derivatives will be broadly defined, and as an example, two basic derivatives, futures and forwards, will be examined in detail.Photo Credit: Twentieth Century Fox Film Corporation
A derivative refers to any financial instrument that derives its value from some underlying object, whether that is an asset, an index value, a rate, or even something as abstract as the weather. Derivatives are constructed as a contract between two parties, and are typically time-dependent. The details of the contract (such as the length of the contract, the underlying object to be tracked, the relevant ending values or prices, and the way the contract will be settled) are established when the derivative is created. Derivatives can be bought and sold in two distinct markets: The over-the-counter (OTC) market or on public exchanges. OTC markets involve a direct connection between two parties, and are generally without much oversight, meaning that an OTC derivative is only as good as the credit of each party involved. Exchange traded derivatives, on the other hand, are supervised and backed by the exchanges themselves. Liquidity on an exchange tends to be much higher, and counterparty risk is eliminated. However, the unstructured nature of OTC markets allows for greater flexibility in creating derivatives, which can be appealing to parties who have unusual or very specific needs in a derivative contract.
The distinction between OTC and exchange trading is important when defining futures and forwards, which are among the simpler types of derivatives. A forward contract gives the holder the obligation to buy (or sell, depending on how the contract is structured) a particular asset at a pre-specified time and price. For example, a contract could be written such that one party agreed to pay $100 to the other party in exchange for a particular stock in three months from the initiation of the contract. The common terminology is to refer to the buyer as having a “long” position in the contract, and the seller as having a “short” position. Because forwards are traded in OTC markets, they are not standardized, and thus are highly customizable; meaning a buyer or seller can design a contract to fit their exact needs as long as they could find someone to take the opposite position on the other side of the contract. However, as mentioned above, each party in a forward contract is subject to the credit risk of the counterparty, meaning that one of the parties might default on their obligation to buy or sell. Also, because a forward is a specific contract between two parties, they can be difficult to move or transfer.
Investors looking for a safer and more liquid alternative can turn to futures contracts. Futures are similar to forwards in that they are obligations to make a transaction at a specified time and price, but unlike forwards they are traded on exchanges like the Chicago Mercantile Exchange (CME). The exchange format eliminates counterparty risk through the use of margin accounts. Each party is required to deposit money in a margin account (maintained by the clearing house of the exchange) as collateral equal to some portion of the notional value of the futures contract.
After a futures contract is initiated, it is marked-to-market on a daily basis (meaning the value of the contract is determined based on the current price of the underlying asset relative to the price specified in the futures contract). Any change in the value is moved from the margin account of the position that lost money to the account of the position who gained. For example, suppose the price of the underlying asset increased in value. The long position in the contract would now be worth more (because the asset they are obligated to purchase at a given price is now worth more), and the short position would be worth less. To account for the change, the appropriate amount of money would be transferred from the margin account of the short position to that of the long position. If the amount of money in one party’s margin account gets too low (due to adverse movement of the price of the underlying), the exchange clearing house issues a “margin call”, meaning that party must deposit more money in their margin account to maintain the required collateral. If that party is unable to replenish their margin account, the contract is closed out, and the positions are settled with the cash in the margin accounts. This method of collateralizing effectively removes counterparty default risk from futures contracts. It should be noted that forward contracts can also use a margin account, but this must be negotiated beforehand by both sides of the contract, and generally managed by an outside third party. This additional layer of complication generally dissuades buyers and sellers of forwards from using margin accounts.
The payoffs from forwards and futures are fairly simple, the value of the contract at expiration will be the difference between the contract price and the market price of the underlying asset, plus any additional transaction costs. A common use of these contracts is as a hedge against future market movement. For example, a farmer could write a contract to sell his harvest of corn at a given price in six months. This way, regardless of the price of corn in six months, the farmer would have locked in a sales price. For this reason, a large number of futures and forwards are issued based on the prices of commodities, or on interest or exchange rates.
While originally designed to ensure future sale or purchase prices of particular assets, these contracts are often times settled without any transfer of underlying assets taking place. Returning to the earlier example, the contract could either be settled by the farmer actually delivering the physical corn to the party on the other end of the contract, or the price difference (between the market and contract price of corn) could be settled by a cash payment between the two parties. Cash settlement is an increasingly popular method for closing out these contracts, because it allows parties to hedge (or speculate on) a price without having to deal with the hassle of actually buying or selling a physical asset.
While futures and forwards represent an obligation to purchase or sell an asset, there are also contracts that give parties the option to buy or sell, but not the obligation. These option contracts will be the subject of the next post in this series about derivatives.