Derivatives
Derivatives
Derivatives
Forward contracts are agreements where one party agrees to buy a commodity at a specific price on a
specific future date and the other party agrees to make the sale. Goods are actually delivered under
forward contracts. Unless both parties are financially strong, there is a danger that one party will default
on the contract, especially if the price of the commodity changes markedly after the agreement is
reached.
Future Contract
A futures contract is similar to a forward contract but with three key differ- ences:
Futures contracts are “marked to market” on a daily basis, meaning that gains and losses are
noted and money must be put up to cover losses. This greatly reduces the risk of default that
exists with forward contracts.
With futures, physical delivery of the underlying asset is never taken—the two parties simply
settle with cash for the difference between the contracted price and the actual price on the
expiration date.
Futures contracts are generally standard- ized instruments that are traded on exchanges,
whereas forward contracts are
Future/Hedging/Swap
Futures are used for both speculation and hedging. Speculation involves betting on future price
movements, and futures are used because of the leverage inherent in the contract. Hedging, on the
other hand, is done by a firm or an individual to protect against a price change that would otherwise
negatively affect profits. For example, rising interest rates and commodity (raw material) prices can hurt
profits, as can adverse currency fluctuations. If two parties have mirror-image risks, they can enter into a
transaction that eliminates, as opposed to transfers, risks. This is a “natural hedge.” Of course, one party
to a futures contract could be a speculator and the other a hedger. Thus, to the extent that speculators
broaden the market and make hedging possible, they help decrease risk to those who seek to avoid it.