Fundamentals of Derivatives: Futures and Forwards

A derivative (financial instrument) is a financial contract whose value is determined by the value of the underlying asset: a stock, bond, currency, commodity, index, or interest rate. Derivatives perform two key economic functions: hedging risk (transferring undesirable risk to another party) and speculation (accepting risk in order to earn a profit). The global derivatives market, by open positions volume, exceeds $600 trillion—several times greater than global GDP.

Futures contracts are standardized agreements to buy or sell an underlying asset on a specific date in the future at a pre-agreed price. Key characteristics: standardization (a contract traded on the exchange has a fixed lot size, expiration date, delivery rules), margining (participants post initial margin and maintain maintenance margin; daily calculation of profit/loss—marking to market), the role of the central counterparty (CCP clears deals, eliminating the counterparty credit risk). Examples of futures: WTI Crude (1,000 barrels), E-mini S&P 500, Bund futures (German government bonds), gold (100 troy ounces).

Forward contracts are similar to futures but are traded on the over-the-counter market (OTC). Parameters are negotiated individually. Key differences from futures: no standardization (any asset, any term, any volume), no daily calculation (P&L realized at expiration), presence of counterparty credit risk (no CCP). Forwards are widely used in the currency market (FX forwards), interest rates (FRA—Forward Rate Agreements), commodity markets.

The pricing of futures and forwards is based on the cost-of-carry principle: Fair Value = Spot × e^(r−q)×T, where r is the risk-free rate, q is the dividend yield or yield of the underlying asset, T is the time to expiration. Basis (basis) is the difference between the futures and spot price. As the expiration date approaches, the basis tends toward zero. Deviations from fair value create arbitrage opportunities, which quickly disappear.

Practical application includes the following examples: an importer hedges currency risk by buying a currency forward, an airline locks in the price of fuel through crude oil futures, a portfolio manager protects a portfolio from a market decline by selling index futures. Hedging with futures requires calculation of the hedge ratio: HR = (Portfolio Value / Futures Contract Value) × Beta. The correct hedge ratio minimizes residual risk.