Derivatives are one of the most widely traded instruments in financial world. Value of a derivative transaction is derived from the value of its underlying asset e.g. Bond, Interest Rate, Commodity or other market variables such as currency exchange rate. Please read Disclaimer before proceeding.
I will be explaining what derivative financial products are. In particular the article will focus on outlining similarities and differences of forwards and futures.
Examples of Derivative Trades
Swaps, forwards and future products are part of derivatives product class.
- Fx forward on currency underlying e.g. USD
- Fx future on currency underlying e.g. GBP
- Commodity Swap on commodity underlying e.g. Gold
- Interest Rate Swap on interest rate curve underlying e.g. Libor 3M
- Interest Rate Future on interest rate underlying e.g. Libor 6M
- Bond Future (bond underlying e.g. US Government Bond)
Think of a derivative as a wrapper around an underlying asset. Therefore any changes to the underlying asset can change the value of a derivative.
Forward Vs Futures
Forwards and futures are financial derivatives. In this section, I will outline similarities and differences amongst forwards and futures.
Forwards and futures are very similar because they are contracts between two parties to buy or sell an underlying asset in the future. The asset could be bond, or currency or commodity etc.
However forwards and futures have many differences. For an instance, forwards are private between two parties, whereas futures are standardized and are between a party and an intermediate exchange house. As a consequence, futures are safer than forwards and traditionally, do not have any counterparty credit risk.
The diagram below illustrates characteristics of forwards and futures: