What it means
A derivative takes its value from something else: a share index, an interest rate, a barrel of oil, a currency pair. Exchange traded versions standardise the contract size, the expiry date, the settlement method and the quality of any deliverable, so the only variable left to negotiate is the price.
The clearing house is the feature that matters most. It becomes the buyer to every seller and the seller to every buyer, so neither side depends on the other's creditworthiness, and it enforces margin, meaning an initial deposit plus daily payments as prices move.
Daily settlement, usually called marking to market, means gains and losses are paid in cash every day rather than accumulating until expiry. That prevents losses building up unseen, but it also means a hedger needs available cash to fund margin calls even when the underlying commercial exposure has not yet produced any cash movement.
The main alternative is the over-the-counter derivative, negotiated privately between two parties. Those can be shaped to fit an exposure exactly, but they carry counterparty credit risk, are harder to value independently and are much harder to exit before maturity.
Corporate treasurers use exchange traded contracts to hedge commodity input costs, interest rates and currency exposure, while investors use them for leveraged positions and portfolio protection. Under accounting standards the contract sits on the balance sheet at fair value, and hedge accounting is only available where the hedging relationship is formally documented and tested for effectiveness.
In practice
Real-world examples.
Example
An airline expects to buy 2,000,000 gallons of jet fuel next quarter and buys heating oil futures on an exchange as a proxy hedge. The contracts do not match its fuel grade exactly, but they are liquid, cleared and easy to unwind if the flying programme changes.
Example
A pension fund wants to reduce equity exposure ahead of a governance review without selling its underlying holdings and crystallising costs. It sells index futures, which takes effect the same day and can be reversed just as quickly.
Example
A grain merchant sells wheat futures against physical stock sitting in silos. The exchange contract locks in a selling price, and the daily margin flows mean the merchant must keep a working capital facility available to fund cash calls if prices rise before delivery.
Formula
Calculation
Contract notional value = Price x Contract multiplier. Profit or loss = (Exit price - Entry price) x Multiplier x Number of contracts.
A share index future has a multiplier of $50 per index point and trades at 4,800, so one contract represents 4,800 x $50 = $240,000 of index exposure. A fund buys 4 contracts, giving notional exposure of 4 x $240,000 = $960,000, and posts initial margin of $12,000 per contract, or 4 x $12,000 = $48,000 in total.
The index then rises to 4,860, a gain of 4,860 - 4,800 = 60 points. The profit is 60 x $50 x 4 = $12,000.
That $12,000 is $12,000 / $960,000 = 1.25% of the notional exposure but $12,000 / $48,000 = 25% of the margin actually posted. The same arithmetic works in reverse, so a 60 point fall would have wiped out a quarter of the margin and triggered a call for more cash.Case study
Seen in the real world.
Fenwick Grain Traders is an illustrative and entirely fictional merchant used here to show how margin discipline works in practice. It held physical wheat and hedged by selling exchange traded futures, so a falling market would cost it on the physical stock and gain on the futures.
Prices instead rose sharply over three weeks. The physical stock gained value on paper, but the futures position lost money in cash, and the clearing house demanded variation margin every single day. Fenwick's hedge was economically sound, yet it nearly failed because the gains sat in unsold grain while the losses had to be paid in cash immediately.
The finance director's fix was to arrange a committed margin facility sized at three times the historic worst monthly margin call, and to model margin cash flows separately from profit. The illustrative lesson is that with exchange traded derivatives the credit risk is largely removed, but it is replaced by a liquidity requirement that a hedger has to plan for.
Watch out
Common mistakes.
- Confusing the notional value of a contract with the amount of money at risk, when the actual exposure is driven by how far the price moves.
- Hedging with futures without arranging liquidity for margin calls, which turns a sound economic hedge into a cash crisis.
- Assuming a hedge automatically qualifies for hedge accounting, when the documentation and effectiveness testing must be in place from the start of the relationship.
Questions
People also ask.
How is this different from an over-the-counter derivative?
Exchange traded contracts are standardised, centrally cleared and easy to exit, while over-the-counter contracts are customised, carry counterparty risk and are usually held to maturity.
What is initial margin?
A good-faith deposit lodged with the clearing house when the position opens, sized to cover a plausible one-day adverse price move, and returned when the position closes.
Do you have to take delivery of the underlying asset?
Rarely, since most contracts are cash settled or are closed out before expiry, though physically settled commodity contracts do require delivery if held to the end.
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