Derivatives act as insurance policies against losses, deriving offsetting returns from underlying assets. Examples of such "insurance policies" are forward commitments.
At the heart of financial and portfolio analysis is the concept of risk. In the relatively simple world of fixed income securities and equities, the risks that analysts and investors often worry about are how market values are impacted and what the potential for a borrower is to default.
And then there is a whole other level of dealing with risk through financial instruments called derivatives. In essence, a derivative offers potential returns that are based on returns of some other underlying security. In other words, a derivative’s performance is derived from the performance of the underlying asset—emphasis on the word “derived” and thus the name “derivatives.”
Where Derivatives Trade?
Derivatives are created on, and traded in, two very different, but interrelated types of marketplaces: derivative exchanges and over-the-counter (OTC) markets. Derivatives that are exchange-traded are standardized, and bought and sold through organized trading facilities. In contrast, OTC derivative contracts are struck between two parties outside the facilities of an organized exchange.
Forward Contracts
In a forward contract, one party agrees to buy an underlying asset from the other party at a predetermined price to settle at some point in the future. At the onset of the forward contract, the two parties agree on the terms and conditions, such as, for example, how the delivery would be executed. In layman terms, the two parties are building a contract from scratch, which is why it is said that forward contracts are customized.
Forward contracts today are created in a huge and private market consisting of financial institutions, governments and corporations. The range of underlying securities is rather wide, from stocks or bonds, to currencies, commodities, even interest rates. Note that in case of interest rate forwards, the contract is not struck on a fixed income security from which the interest rate is derived, but on the actual interest rate itself.
Since the forward market is private, it is also largely unregulated. When two parties commit to buy an asset from, and deliver the asset to, each other, we are talking about a forward contract. But it is not as if ordinary investors can pick up newspapers and find about the contract’s bid and ask in the business section. The reason for this is simple—as little government and regulatory interference as possible. However, this also does not imply that anything shady or fraudulent is going on in the forward markets. We are merely talking about a sensible level of business secrecy.
Futures Contracts
One type of forward commitment is also a futures contract, which resembles a forward contract in all aspects except that the futures contract is a standardized and exchange-traded type of transaction. When a contract is standardized, it means that the exchange sets its expiration date, strike price, underlying asset and how many units of the underlying are going to be included in the contract.
More importantly, with futures contracts the risk of default is virtually eliminated. Unlike forward contracts, with future contracts the futures exchange guarantees to both parties that if one fails to pay or deliver, the exchange will jump in to help. This is why the exchange literally writes itself into futures contracts, so that each party is in the contract with the exchange, rather than with each other.
The futures exchange’s participation in futures contracts is facilitated through clearinghouses. Clearinghouses protect themselves against defaulting parties by requiring that every day each party settles its gains and losses incurred during normal course of business on the exchange. This is called the daily settlement or marking-to-market. At the end of a trading day, daily gains and losses are calculated, they have to be credited or debited to each party. As a result, looses cannot accumulate to the point of either party defaulting.
Just because futures contracts are marked-to-market and the possibility of default is thus minimized, it does not mean defaults are more likely for forward contracts. Indeed, parties to forward contracts must meet very high creditworthiness standards. The fact remains, however, that in the forward markets there are no guarantees that terms of a contract are going to be respected. And since there are no performance guarantees, the futures markets have experienced credit losses, while the futures markets have not.
Swaps
Another type of forward commitments is a swap, which is really more like a series of forward contracts. In a swap, two parties agree to exchange a series of future cash flows at pre-determined intervals. Typically, one party pays a series of fixed payments, while the other pays a series of floating payments. Traders commonly refer to swap payments as either floating (variable) or fixed.
Much like forward contracts, swaps are also private and unregulated transactions. Swaps are also considered the most successful of all derivative instruments. The most common type of swap is when one party commits to paying a series of fixed-rate payments in exchange for the other party’s series of floating rate payments, which are usually related to floating-rate payments due on a separate loan. So, when floating-rate payments on the swap and loan cancel each other out, what remains are fixed-rate payments. In essence, the swap has converted a floating-rate loan into a fixed-rate loan.
