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Basics of Derivatives: Forward and Futures
Basics of Derivatives: Trading the Future
A derivative is a financial instrument whose value is “derived” from an underlying asset, such as a stock, bond, or commodity. They are the essential building blocks for risk management in modern financial engineering.
1. Why Use Derivatives?
Derivatives are primarily used for two purposes:
- Hedging: Reducing or neutralizing risk (like an insurance policy).
- Speculation: Betting on future price movements to gain profit.
2. Forward Contracts: A Simple Agreement
A forward contract is a customized agreement between two parties to buy or sell an asset at a specified price on a future date.
Two parties agree on a price (Formula Price) for a future transaction.
The underlying asset price fluctuates in the market.
The transaction is executed at the agreed price, regardless of the current market price.
Profit or loss is realized based on the difference between the agreed and market prices.
3. Forwards vs. Futures
While a Forward is a private, customizable agreement, a Futures contract is standardized and traded on an exchange, which significantly reduces counterparty risk.
💡 Professor’s Tip
In a derivative contract, one person’s gain is exactly equal to another person’s loss. This is why we call the derivatives market a Zero-Sum Game in its purest form.