The Trade Lifecycle: Behind the Scenes of the Trading Process, 2nd Edition

Chapter 5 Derivatives, Structures and Hybrids

Any trade that derives from an underlying asset, but does not involve the direct purchase or sale of that asset, is known as a derivative. Common classes of derivatives are forwards and futures, swaps and options. Derivatives are often divided into linear and nonlinear.

5.1 Linear

The simpler set of derivatives is linear products. This means that the payoff is related linearly to the spot price of the underlying asset. (We disregard unexpected or unknown extra payments, such as share dividends, from this consideration.)

Suppose on 3 January 2014 you purchase a six-month forward silver contract at USD 17.05 per troy ounce. The profit or loss six months later is shown in the example in Table 5.1.

Table 5.1 Profit at various final spot prices

Spot price on 3-Jul-14	Profit per unit
15.05	−2
16.05	−1
17.05	0
18.05	1 etc.

Clearly the profit is linearly related to spot price. The same is true for swaps.

Differences between futures and forwards

In the financial industry, there are some technical differences between trades called forwards and futures as outlined in Table 5.2, although the overall purpose is the same, namely to lock in a price now for some exchange of assets in the future.

Table 5.2 Futures vs. forwards

Futures	Forwards
Exchange traded directly by the counterparties or through intermediaries who deal on their behalf	Direct agreement between the two counterparties with no other involvement ...