When people think of investing, they often imagine traditional assets like stocks and bonds. However, a significant portion of the investment market is dedicated to financial instruments known as derivatives. These complex instruments have become increasingly important in modern finance. This series will explore common types of derivatives and how they are used by investors and financial institutions. In this post, we will broadly define derivatives and examine two basic types: futures and forwards, in detail.
What Are Derivatives?
A derivative is a financial contract whose value is derived from the performance of an underlying entity. This entity can be an asset, index, interest rate, or even an event like weather. Derivatives are constructed as contracts between two parties and are typically time-dependent. Key elements of the contract, such as the length, underlying object, relevant prices, and settlement method, are established when the derivative is created.
Derivatives can be traded in two primary markets: over-the-counter (OTC) and on public exchanges. OTC markets involve direct agreements between two parties without much regulatory oversight, meaning the value and reliability of an OTC derivative depend heavily on the creditworthiness of the parties involved. On the other hand, exchange-traded derivatives are standardized, liquid, and backed by the exchanges, significantly reducing counterparty risk. This structure ensures higher liquidity and eliminates the risk of default by the other party. However, the flexibility and customization offered by OTC markets are attractive to parties with specific needs that standardized contracts cannot meet.
Key Types of Derivatives: Futures and Forwards
Forwards
A forward contract obligates the buyer to purchase, and the seller to sell, a specific asset at a predetermined future date and price. These contracts are highly customizable and are typically traded OTC. This customization allows parties to tailor the contract to their exact needs. However, because these contracts are private agreements, they expose each party to the other’s credit risk. If one party defaults, the contract may become worthless. Additionally, forwards are relatively illiquid compared to exchange-traded derivatives, making them harder to transfer or sell before the contract’s maturity.
Example: A forward contract might stipulate that one party agrees to buy a certain amount of oil at $70 per barrel in six months. The buyer, holding a long position, is obligated to purchase the oil at the agreed price, while the seller, holding a short position, is obligated to deliver the oil at that price.
Futures
Futures contracts are like forwards in that they are agreements to buy or sell an asset at a future date for a price agreed upon today. However, unlike forwards, futures are standardized and traded on exchanges such as the Chicago Mercantile Exchange (CME). This standardization and the involvement of an exchange reduce counterparty risk significantly. Each party must deposit funds into a margin account as collateral, which the exchange’s clearinghouse manages. The contract is marked-to-market daily, meaning that the value is adjusted based on the current market price of the underlying asset, and gains or losses are transferred between the parties’ margin accounts accordingly.
Example: Suppose the underlying asset in a futures contract is gold. If the market price of gold increases, the long position gains value, and money is transferred from the short position’s margin account to the long’s. Conversely, if the price drops, the long position loses value, and funds move in the opposite direction. If the balance in a party’s margin account falls below a certain threshold due to adverse price movements, a margin call is issued, requiring additional funds to be deposited to maintain the position. If the margin call is not met, the position may be liquidated.
Usage and Benefits
Derivatives like futures and forwards are crucial for hedging and speculative strategies. Hedging involves taking a position in a derivative to offset potential losses in another investment. For example, a farmer might use a forward contract to lock in the price of his corn crop, ensuring a stable income regardless of market fluctuations. This strategy protects against price volatility, providing financial stability.
On the other hand, speculators use derivatives to bet on the future direction of market prices, seeking to profit from price movements. While this can lead to significant gains, it also involves substantial risk, as incorrect predictions can result in large losses.
Originally, derivatives like futures and forwards were designed to ensure stable prices for commodities and other assets. However, many of these contracts are now settled in cash rather than by delivering the physical asset. Cash settlement simplifies the process, allowing parties to focus on price movements without the logistical challenges of handling the underlying asset.
Historically, only large investors had access to forwards and futures trading due to their complexity. More recently, retail brokerage platforms like Robinhood allow everyday investors to trade some of these types of derivatives. Generally, we caution against using forwards and futures because of the large collateral requirements and the heightened volatility that comes with the inherent leverage.
Conclusion
Futures and forwards are fundamental types of derivatives that provide tools for risk management and speculative opportunities in the financial markets. Understanding their mechanics and inherent risks is crucial for investors and financial institutions. These instruments offer various benefits, such as hedging against adverse price movements and enabling speculation on future price changes. However, for most investors we believe using forwards and futures is unnecessary to achieve long-term investing goals. In the next post, we will delve into options contracts, which provide the right—but not the obligation—to buy or sell an asset, adding another layer of complexity and opportunity to the world of derivatives.
For investors or retirement plan participants with questions on utilizing derivatives, contact Empirical Wealth Management. We can help you navigate your investment options and make informed decisions for a secure financial future.
