INTRODUCTION TO DERIVATIVE
Commodities
CONTRACTS
DERIVATIVE MARKET
● Market are used to transfer goods, services,
funds or risks
● Derivative Market is a market developed
over time to transfer risk from one party to
another
DERIVATIVE CONTRACT
● The transfer of risk from one party to another
is done through a Derivative Contract which
can be seen in simple terms as a bet on
which way a particular number such the price
may move in the future.
● Derivative Contract derives its value from an
underlying asset such as stock, currency or
commodity, hence the name derivative.
● In a derivative contract two parties will take a
stance on the value of the derivative, one
side will have the right generally to receive
payments while the other will be obligated to
make those payments. The size and direction
of payments will be based on that underlying
instrument
COMPONENTS OF A DERIVATIVE
CONTRACTS
1. An Underlying Asset
- a derivative contract will derive its
value based on the dynamic value of
an underlying asset. A few of the
most common underlying assets in
the derivative markets are:
a. Stocks
b. Bonds
c. Currencies
d.
e. Market Indices or Indices
f. Interest Rates
2. Counterparties with Long/Short Positions
- In a derivative contract one party is
described as holding a long position
while the other is in a short position.
- if a derivative can be thought of as a
bet on a number then the simplest bet
is whether that numbers going to rise
or fall
- a bet that the number is going to rise
in the derivative markets is generally
described as a long position
3. An Expiration or Maturity Date
- Derivative contracts will also include
an expiration date.
- This is the date when the contract
agreement ends and any differences
in the two positions are finally settled
- Derivatives will also specify delivery
type at expiration when applicable:
a. Physical Delivery - this is
common with commodity
derivatives. Physical delivery
means that at the expiration
date, the quantity of the
underlying asset specified in
the contract will actually be
physically delivered to the
buyer of the contract
b. Cash - Settled - means that
the differences in the
counterparties’ positions will
be settled in cash rather than
delivering the underlying
asset
OVER-THE-COUNTER VS EXCHANGE
TRADED
Derivative contracts can be entered and traded
over-the-counter often referred to as OTC or through
exchanges
● Over the counter or OTC derivatives are
customized contracts made through a broker
dealer or directly between two counterparties.
 ● Exchange-traded derivatives are
standardized contracts that are freely traded
on formal organized exchanges
USES OF DERIVATIVES CONTRACTS
Derivatives are generally used for two key purposes:
hedging and speculating
● Hedging - involves protecting a current
financial position from potential losses.
Hedgers typically have an underlying long or
short position
● Speculating - involves trying to make
guesses about the direction of the underlying
asset’s value to make a profit.
TYPES OF DERIVATIVE CONTRACTS
1. Forwards
2. Futures
3. Swaps
4. Options
Forwards, Futures and Swaps are deemed to be
forward commitments because both parties to the contracts
are obligated to deliver. Options are often referred to as
contingent claims because the contract is dependent on a
future event.
FORWARD CONTRACTS
● A Forward Contract is an agreement between
two parties to exchange an asset for a
pre-specified price on a specific date in the future.
PURPOSE OF A FORWARD CONTRACTS
- Forwards are over-the-counter contracts.
Although they can be used for speculating,
the customizability makes forwards very
useful for hedging.
- For example, industries that heavily rely on a
commodity such as an airline on jet fuel, can
hedge the price of fuel using forwards to
reduce volatile prices.
COMPONENTS OF A FORWARD CONTRACT
1. Underlying Asset - whether that be a
commodity, stock, interest rate or currency
2. Delivery Date - when will the commodity be
delivered
3. Specified Price - the price that are going to
agree upfront
4. Quantity
5. Type of Delivery - physically settled or cash
settled
FUTURES CONTRACT
● A Futures Contract is similar to a forward
contract. It is an agreement to exchange an
underlying asset for a pre-specified price at a
specified date in the future.
THE MAJOR DIFFERENCES
1. Futures contracts have standardized contract
terms
2. Futures contracts are traded on exchanges
rather than over the counter
3. Futures contracts involve margins
PURPOSE OF A FUTURES CONTRACTS
● Futures contracts are often used for hedging,
however the liquidity of futures contracts and
the ability to leverage through margins make
futures attractive for speculating
COMPONENTS OF FUTURES CONTRACTS
1. Underlying Asset - whether that be a stock, a
stick index, commodity, currency and so on
2. Delivery Date - often quoted in months
3. Specified Price
4. Contract Size - standardized contract
5. Type of Delivery - whether that be physical
delivery or cash settled
6. Tick Size - the minimum increments that the
price will move by
7. Initial Margin and Maintenance Margin
OPTIONS CONTRACTS
● An Option Contracts gives one party the right,
but not obligation, to buy or sell an underlying
asset at a specific price by or at a specific
date
● If the party that has the right to buy or sell
chooses to exercise their option, the
counterparty to the contract must deliver. The
two basic options include
a. Call Option - the option to buy an
underlying asset at a specified price in
the future
 b. Put Option - the option to sell an
underlying asset at a specified price in
the future.

PURPOSE OF AN OPTION
● Options are used for both hedging and
speculating purposes
● Since options give the right but not obligation
to exercise, investors can use options to
speculate while also reducing downside
losses.
● Long and short positions on calls and puts
can be combined in many different ways to
serve different purposes

COMPONENTS OF AN OPTION CONTRACT

1. Underlying Asset - commodity like gold or an
equity
2. Expiration Date
3. Strike Price
4. Contract Size
5. Type of Delivery
6. Option Premium - how much is this option
going to cost
7. American vs European

SWAP CONTRACTS
● A Swap Contract is a derivative in which two
counterparties exchange cash flows (known
as “legs”) over a period of time. Often one leg
will be a fixed payment, while the other will be
a floating payment

COMPONENTS OF A SWAP CONTRACTS

1. Underlying Asset - fixed coupon bond, a
floating rate, or an equity
2. Notional Amount - not normally paid or
received by the counterparties instead it used
to calculate the cash flows that will be
swapped
3. Maturity Date - outlines the period over which
cash flows will be swapped.
4. Fixed/Floating Rated - Fixed Rate will be set
at the start of the swap and it will remain
fixed for the entire term to maturity.
5. Payment Frequency - quarterly, semi-annually
or annually