The key difference between derivatives and futures is that derivatives are financial instruments whose value depends on the value of another underlying asset whereas futures is an agreement, to buy or sell a particular commodity or financial instrument at a predetermined price at a specific date in the future. Due to the steady growth in financial markets, a number of investors increasingly invest in many financial instruments. Such instruments carry financial risks as their value is subjected to fluctuations. Derivatives are used to eliminate such risks by providing certainty for a future transaction, including derivatives. Thus, the relationship between derivatives and futures is that futures are a form of derivatives.
CONTENTS
1. Overview and Key Difference
2. What are Derivatives
3. What are Futures
4. Side by Side Comparison – Derivatives vs Futures
5. Summary
What are Derivatives?
Derivatives are financial instruments whose value depends on the value of another underlying asset. Derivatives are used to hedge financial risks (to reduce the risk of a financial asset in relation to the uncertainty of what its future value will be) and given below are the widely used forms of derivatives.
Forms of Derivatives
Forwards
A forward contract is a contract between two parties to buy or sell an asset at a specified price on a future date. Forwards are over the counter (OTC) instruments, which mean that they can be customized according to any transaction requirement between two parties without a structured exchange.
Futures
A future is an agreement to buy or sell a particular commodity or financial instrument at a predetermined price at a specific date in the future. Futures are exchange traded instruments, which means that such contracts are only traded in structured exchanges and are only available in standard sizes.
Options
An option is a right, but not an obligation to buy or sell a financial asset on a specific date at a pre-agreed price. There are two main types of options, ‘call option’ and ‘put option.’ A call option is a right to buy whereas put option is a right to sell. Options may be exchanged traded or over the counter instruments.
Swaps
A swap is a derivative through which two parties arrive at an agreement to exchange financial instruments. While the underlying instrument can be any security, cash flows are commonly exchanged in swaps. Swaps are over the counter instruments.
What are Futures?
A futures contract is an agreement to buy or sell a particular commodity or financial instrument at a predetermined price at a specific date in the future. Futures are exchange traded instruments thus are trading in futures exchange. Some futures contracts require physical delivery of the underlying asset while others are settled in cash.
Advantages of Futures
High Liquidity
Futures are highly liquid derivatives (convenient to buy and sell fast) since they trade through an exchange.
Low Default Risk
Since they are regulated by exchange, futures contracts have a low default risk compared to derivatives such as forwards.
Low Commission Charges
Commission charges payable for futures trading is relatively low compared to other derivatives
Disadvantages of Futures
Lack of Customization
Since futures contracts are standardized instruments available in standard sizes, they cannot be tailor-made to transaction requirements.
Minimum Deposit Requirement
There is a minimum deposit requirement to be met prior to obtaining a futures contract, thus at times; the benefit gained from low commission charges may be offset against the deposit.
Figure 01: Chicago Mercantile Exchange & Chicago Board of Trade is the largest futures exchange in 2015
What is the difference between Derivatives and Futures?
Derivatives vs Futures |
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| Derivatives are financial instruments whose value depends on the value of another underlying asset. | Futures is an agreement, to buy or sell a particular commodity or financial instrument at a predetermined price at a specific date in the future. |
| Nature | |
| Derivatives may be exchange traded or over the counter instruments. | Futures are exchange traded instruments. |
| Types | |
| Forwards, futures, options, and swaps are popular types of derivatives. | Futures are one type of derivative instruments. |
Summary – Derivatives vs Futures
The difference between derivatives and futures mainly depends on their scope; derivatives are broader in scope as it involves many techniques while futures contracts are narrow in scope. The objective of both is similar since they attempt to mitigate the risk of a transaction that will take place in the future. In 2010, it was estimated that the world derivative market to have exceeded $1.2 quadrillion. Further, CME Group Inc. (Chicago Mercantile Exchange & Chicago Board of Trade) became the biggest futures exchange in the world in 2015 with more than $1 quadrillion turnovers.
Reference:
1.”Derivative.” Investopedia. N.p., 17 Mar. 2016. Web. 04 May 2017. <http://www.investopedia.com/terms/d/derivative.asp>.
2. “Finance Learners.” Advantages and Disadvantages of Futures. N.p., n.d. Web. 05 May 2017. <http://financelearners.blogspot.com/2011/04/advantages-disadvantages-futures.html>.
3. “11 Biggest Futures Exchanges in the World 2015.” Insider Monkey. N.p., n.d. Web. 05 May 2017. <http://www.insidermonkey.com/blog/11-biggest-futures-exchanges-in-the-world-2015-381668/11/>.
Image Courtesy:
1. “Cme building aerial view” By CME Group/Henry Delforn/Allan Schoenberg – CME Group (CC BY-SA 3.0) via Commons Wikimedia