Finance Explained- Derivatives (Futures/Forwards)

The world of finance is often over-glamourized and made out to be far more complicated than it is in reality.

One such area of finance that is the poster-child of corporate finance and indeed Wall Street is that of derivatives. One of the least understood topics by your Average Joe, casually slipping the name into a conversation with those less knowledgeable than you is enough inflate their opinion of you tenfold.

Yet these are not particularly complicated beasts to understand. In fact, even I, a 22 year old student with, let's be honest, a fairly average level of intellect and an even lower level of work ethic, find them relatively easy to understand, and would like others to feel the same way too. So with that in mind, here is the first of a series of explanations of derivatives to try and make them more understandable and indeed accessible to the average person on the street.

Futures/Forwards

Put very simply (and these are simple derivatives), a future/forward is just an agreement to either purchase or sell something in the future. They are entered into at a certain point in time, and both parties agree that in another certain point of time in the future, they will exchange some underlying asset at a pre-determined price. It is a contract, thus both parties have no option but to honour their side of the contract, lest they be willing to face legal action.

The long position agrees to purchase the underlying asset, while the short position agrees to sell it to the long position at the pre-arranged price. So let's assume, for example, that you own 1 Bitcoin (lucky you!). You have seen the spectacular price rise, but are worried that it won't run for much longer. You decide to enter into a future contract, where you will sell your 1 Bitcoin in 3 months time for $10,000. You will thus be in the short position on the future.

If the price shoots up to $12,000, you still have to sell your Bitcoin for $10,000, thus you 'lose out'. However, if the price had tanked (as you suspected) to $8,000, you would have protected yourself from the fall. You will thus profit when the price falls, and lose out when the price rises. The long position will have the exact opposite payoff. If the price screams up to $12,000, they still only have to pay $10,000, and then can sell it on the market and realise that profit. If the price falls, they are paying more than the market price and thus are losing.

A big issue with these contracts is counter-party risk. How will you be sure that the person will buy your Bitcoin? They may bugger-off to North Korea to avoid paying. This is the key difference between a future and a forward- a future is regulated by an exchange with a clearinghouse, whereas a forward is just an agreement between 2 parties with no middle man. the clearinghouse makes each party put down some money initially as a margin, then it uses these margin balances to pay whoever is winning every day (e.g. if the price rises, the clearinghouse will use short position's margin to pay the amount they lose to the long position). If your margin falls below a certain level, you will be asked to top it up again, thus both parties are protected from the other party pulling a runner if they are losing.

I hope this was a useful explanation of futures/forwards. I'll continue covering different derivatives in the coming days if the explanations are appreciated!

Happy Steeming!