Derivatives_Futures_Swaps

Derivatives are financial instruments whose value varies based on changes in underlying variables. Derivatives include futures and swaps, both of which are essentially contracts to purchase a commodity at some point in the future. Derivatives get their name from the fact that they are essentially secondary investments; there has to be a market in which some asset is traded before there can be a derivative. Derivatives may be based on stocks, bonds, commodities, or even interest rates or exchange rates.

To understand derivatives better, it’s helpful to consider a specific kind of derivative. A future is a contract to buy or sell something else at a specified time in the future. A futures contract requires the person who holds the contract to buy the specified commodity at a specified point in time, at the price specified. (This makes it different from an option, which allows the holder to buy but does not require it.) If I buy July corn futures, I’m agreeing to buy corn in July for a specified price. Of course, I could decide to sell my futures before July, assuming I can find a buyer, but someone will buy that corn in July. The point of futures is to reduce risk and uncertainty, which is why futures are so common in the agricultural commodities market.

Swaps are even more abstract than futures. In a swap, two parties agree to trade two cash flows, often interest on a sum of money that is not actually exchanged. For example, parties may trade a fixed interest rate for a variable interest rate (tied to some external benchmark rate like LIBOR). Periodically, Party A makes interest payments at the fixed rate to Party B, who in return makes interest payments at the variable rate to Party A.