Derivatives are financial instruments used by investment professionals that, as their name suggests, have no value of their own but are derived from another financial asset, the 'underlying'. These products are used for various purposes: to manage risk through forms of hedging; to speculate on changes in the prices of certain assets, over time (speculation) or between different markets (arbitrage); to leverage investments. The main types of financial derivatives are futures, options, forwards and swaps.
The main function of futures, which are essentially contracts (used by market professionals), is to commit the parties to buy and sell an asset, fixing in advance 1) the price, 2) the date of exchange. They are, if we want to be more precise, standardised instruments, traded on regulated markets, with the so-called "obligation to execute". In the futures market, at least two of the above-mentioned functions of derivatives are intertwined: a) hedging against a risk, when one fears that a certain asset may appreciate/depreciate; b) speculation, when one expects an asset to increase or decrease in value. One of the advantages of futures is the versatility of the underlying asset, which includes a wide range of assets, including commodities.
Let us move on from the obligation to the right to buy or sell an asset at a fixed date and price: these are specific derivative instruments called options. They are therefore either (i) a right to sell, in which case they are called put options, or (ii) a right to buy, in which case they are called call options. Again, their use by market professionals is based on reasons of risk hedging or speculation; it is clear that, compared to futures, the right to buy and sell limits the risk, since either you decide to exercise your right or you simply pay the premium for the option. According to the website of Consob (the Italian financial market regulator), covered warrants, i.e. "securities with an option embedded in them", can also be considered as this type of derivative.
Like futures, forwards are contracts between contracting parties for the purchase and sale of an asset, the price and date of which are fixed in advance. So what makes them different from futures? Quite simply, forwards are not traded on regulated markets and are not standardised products.
Like other derivative products, swaps are contracts used by investment professionals and financial institutions to exchange future cash flows, typically interest rates. The four most common types of swap derivative contracts are listed below, in accordance with the Consob website.
