Key Takeaways
• A futures contract allows a trader to guarantee the price and quantity of a commodity for delivery at a date in the future.
• A forward differs to a future by where it is booked and provides greater flexibility in it's terms.
• A swap enables a counterparty to exchange cash flows between different price indexes or a fixed rate.

An intro to financial derivatives

My last blog was the 2nd in my series on commodities where we took a look at the different ways a financial institution can influence commodity markets, and how a commodity can become traded. This blog will extend upon traded commodities to look at the main financial derivatives that can be created and the benefits they present.

This blog will take a look at forwards, futures and swaps; my next blog will look at final piece of the puzzle, option contracts, which are a little more complicated. I will generally use commodities as examples in these explanations, however note that financial derivatives are not limited to just this asset class, so where you see 'commodity', you can replace it with 'asset'.

The future contract

A future is a contractual obligation between two counterparties to purchase or sell a given commodity, at a specific volume and price (known as the futures price) for delivery at a specified date in the future. The buyer of a future contract will benefit as they can guarantee the price of a commodity to be delivered at a date in the future. The seller in the future contract benefits from the guaranteed sale of a specific volume of commodity at a price in the future. Both participants benefit by removing the price volatility for the asset in the sale at the future date.

One example may be an airline, who might like to use a future contract to fix the price of jet fuel for the future. By fixing the price, the airline can better estimate the costs of flights and set prices of tickets. The supplier of jet fuel has a guaranteed sale, and the airline have a guaranteed price that is not impacted by the volatility of market price for jet fuel in the time-frame of the contract.

While a future has many practical benefits, they are not often seen to expiry as a financial derivative. Roughly 95% of futures contracts are settled before expiry, and the delivery of the asset is never made. The two counterparties in the contract will settle a difference in payment between the market rate and the futures price, known as 'marking to market'. For example, if a futures contract is made to buy one ounce of gold at £300 per ounce, and at expiry, the market value of gold is £310 an ounce, the seller of the contract will pay the buyer £10, as they are in theory buying gold at £310 in the market, and selling it (at the futures price) of £300.

Over-the-counter vs exchange trading

A future and a forward contract differ in two main ways: where the trade is made and the terms of the contract. A futures contract is placed through an exchange that uses a central clearing house (CCP). The CCP acts as the buyer to the seller and the seller to the buyer, thus guaranteeing the terms of the trade to both counterparties, even in the event of a default from one of the counterparties. Participants in the contract will pay a small deposit, known as margin, to the clearing house that enables them to guarantee the terms. With the CCP, the market of participants are protected from potential knock-on effects of a single counterparty defaulting, and thus causing other counterparties unable to fulfil their onward financial obligations.

A further difference between a future and forward lies in the terms of the trade, and what can be customised in the transaction. Exchanges operate in a uniform way that specify the terms of the contract for individual commodities. For example, this can control the trading units used for a commodity, along with how a price is quoted (currency), how the trade is settled, which months delivery can take place and margin requirements.

Within commodities, the standardisation of trading can be hugely beneficial. This is because commodities can exist in many different forms to introduce other variables on the commodity such as commodity make-up, refiners, approval of content and delivery volumes.

With a forward contract, the terms of the agreement are made between the two counterparties upon the same factors the exchange standardises. This flexibility allows each party to hedge risk more specifically, or to obtain exposure that otherwise wouldn't ordinarily be available in the exchange.

The margin requirement of the exchange had previously been an outstanding difference between the forward and future, however due to evolving regulatory requirements, the margin requirements between OTC trading are now relatively similar to that of an exchange.

Swaps

A swap contract creates an exchange of cash flows between two parties. The swap is typically made for long periods of time (more than 1 year) and the underpinning cashflows between the two will be based upon different price indexes.

A typical swap will involve the exchange of a fixed rate with that of a variable rate, thus allowing one party to guarantee outgoing cash flows and providing the other party with exposure to a floating rate. The exchange of cash flows will take place at the agreed upon tenor until expiry.

The notional of the trade will determine the payout that is made between the counterparties. For example, bank A and bank B may enter into an interest rate swap. Bank A pays bank B 5% interest and bank B pays the national bank rate. The notional for the swap may be £100 with tenor of 3 months, and expiration in 1 year.
So if after 3 months the bank rate is 4%, bank B will pay bank A 1% (5% - 4%) of £100. If, after 6 months, the bank rate is 7%, bank A will pay bank B 2% (7% - 5%) of £100. These exchanges of cash flows will take place until expiration.

Within commodities, the use of a swap can vary by nature of the commodity. For example, gold has a floating lease rate (the interest rate on a gold-backed loan), and can therefore be swapped with a fixed lease rate. You can also have swaps on the actual floating price of the commodity itself.

Swaps are typically used for hedging risk; if a bank is exposed to the underlying movement of a price index, they can fix their exposure by entering into a swap for a fixed rate. On the contrary, another bank can obtain exposure to the floating rate, possibly for speculative purposes, while limiting their downward exposure against the fixed rate.

Summary

This blog has taken a brief look at the fundamental financial derivatives of futures, forwards and swaps, all of which are used by financial institutions to manage their exposure and to speculate on the underlying price movements of commodities.

My next blog will complete our view of financial derivatives as I look into the options contract, and the various ways it can be used with commodities.