What are derivatives? Forwards, futures and swaps
A derivative is a contract whose value is derived from something else: a share, an index, an interest rate, a currency, oil or bitcoin. The underlying never has to change hands for the contract to gain or lose value.
The main families
- Forwards: a private agreement to buy or sell something at a set price on a future date. A farmer agreeing a price for next year's wheat is the classic example.
- Futures: standardised forwards traded on an exchange (CME, ICE, Eurex), with fixed sizes and dates and a clearing house in the middle.
- Options: the right but not the obligation to buy or sell (lesson 2.2).
- Swaps: agreements to exchange streams of payments, such as fixed for floating interest (lesson 2.6).
Why they exist
- Hedging: an airline locks in fuel costs, an exporter locks in an exchange rate, a fund protects a portfolio.
- Speculation: taking a view with a small amount of capital, because derivatives are leveraged.
- Arbitrage: profiting when a derivative and its underlying drift out of line, which keeps prices consistent.
Leverage and margin
You don't pay the full value of a futures contract. You post margin, often 5-15% of the notional. One E-mini S&P 500 future controls 50 times the index, several hundred thousand dollars of exposure. A 2% move in the index is a far bigger move relative to your margin. That's the appeal and the danger.
Counterparty risk and clearing
A private forward is only as good as the party on the other side. Exchange-traded futures solve this with a clearing house, which becomes the buyer to every seller and the seller to every buyer, and settles gains and losses every day. After 2008, regulators pushed much of the over-the-counter swaps market into central clearing for the same reason.
Scale
The notional value of outstanding derivatives runs into the hundreds of trillions of dollars, far larger than the stock market. Notional overstates the real risk, since most positions offset, but it shows how central derivatives are to modern finance.
Key takeaway
Derivatives transfer risk from people who don't want it to people who do. Used to hedge they reduce risk. Used with leverage they can magnify it enormously.
Educational content only, not financial advice. Options involve significant risk and are not suitable for everyone.