Futures Contract
What it is
A contract between two parties to buy or sell a commodity at a price agreed today, with delivery and payment at a future date. Traded on an exchange (e.g. CME, ICE); standardized terms; daily margining. First futures: Chicago Board of Trade, 1848 (Corn).
Example (WTI): Buy 2 lots WTI Crude DEC-22 at 50 USD per barrel on CME. One lot = 1,000 barrels, so you have 2,000 barrels. You are locked in at 50 USD per barrel until expiry. If you take physical delivery, you pay 50 × 2,000 = 100,000 USD for the oil. If you close the position (paper settlement) at a different market price, your gain or loss is (Market price minus 50) × 2,000.
Key formulas
Key features
- Linear: Either you make money or lose money; no optionality.
- Settlement: Financially (cash) or physically; most are offset before expiry.
- Standardized: Quality, delivery location, size — to promote liquidity.
- ETRM: Interfaced from trade platforms (e.g. Bloomberg, Trayport); used to hedge physical or in speculation books.
WTI example: change market price — paper vs physical
You bought at the entry price; change the market price to see paper settlement (mark-to-market PNL) and the fixed physical settlement cost if you take delivery.
Forward Contracts
What it is
Same idea as futures — agree today, deliver later — but traded OTC with flexible terms and no daily margining. You trade directly with the counterparty; higher counterparty risk. Used when you need custom quantity, date, quality, or location that exchange futures do not offer.
Futures vs Forwards
| Aspect | Futures | Forwards |
|---|---|---|
| Venue | Exchange (e.g. ICE) | OTC (over the counter) |
| Terms | Standardized | Flexible, negotiable |
| Counterparty | Clearing house in between | Direct with counterparty |
| Counterparty risk | Very low | High |
| Price and volume | Public | Private |
| Settlement | Daily — Mark to Market, margining | Mainly on one date — higher risk |
Use case
Power Purchase Agreement (PPA): Building a power plant; you want a steady buyer (e.g. municipality) for 15–20 years. You enter a long-term PPA for part of the output; for the rest you might use futures. Forwards fill the gap when exchange products do not match tenor or structure.
Swaps
What it is
Two parties promise to exchange the resulting cash flows from their respective assets. Example: Fixed–Floating Interest Rate Swap. LIBOR = London Interbank Offered Rate (rate at which big banks lend to each other).
Day 0 (trade date / inception)
On the day the swap is agreed:
- Terms are set: Notional amount (e.g. 1 million GBP), fixed rate (e.g. 4%), currency, and the floating-rate index (e.g. LIBOR) and fixing schedule.
- No cash changes hands at inception — the swap has zero value at the agreed fixed rate vs the then-prevailing floating rate.
- Contract is documented (e.g. ISDA); both parties are now committed to exchange payments on each settlement date.
Settlement date
On each settlement date (e.g. every 3 or 6 months):
- Fixing: The floating rate (e.g. LIBOR) is observed or “fixed” on the fixing date (usually a few days before settlement). That rate applies for the period just ending.
- Calculate legs: Fixed leg payment = Notional × Fixed rate (known from Day 0). Floating leg payment = Notional × Floating rate (the rate just fixed).
- Net payment: The two amounts are netted. One party pays the other the difference (e.g. if floating > fixed, the fixed-rate payer receives the net from the floating-rate payer).
- Cash flow: Only the net amount is paid; no exchange of full notional.
Key formulas
Why swaps are popular
Low transaction costs (one swap can cover many months); liquid; many flavours (Fixed vs Floating, commodity, currency, calendar). In ETRM they use a different template than futures (two legs, fixing dates, notional).
Change the floating rate — see the difference
Notional and fixed rate are set at Day 0. On settlement, the floating rate (e.g. LIBOR) is known. Change the floating rate below to see how the payments and net result change.
Options
What it is
A right (not obligation) to buy or sell at a strike price. You pay a premium. Call = right to buy; Put = right to sell. Underlying = the asset (e.g. WTI futures).
Example: Refiner wants to cap purchase at 60 USD per barrel. Buys call options, strike 60, premium 2 USD per barrel. 1,000 contracts × 1,000 bbl = 1m bbl. Premium paid = 2,000,000 USD. Break-even = Strike + Premium = 62 USD per barrel.
Key formulas
Option scenario calculator
Profit is unlimited above the strike (the line slopes up with price). Loss is capped at the premium below the strike (the flat floor on the graph). The strike establishes this floor — below it the call expires worthless, so you lose only what you paid, no more.
Option Greeks (in words)
- Delta — How much option value changes when underlying price changes; how much underlying to hold to hedge the option.
- Gamma — Rate of change of Delta when underlying changes; high Gamma means more frequent hedging.
- Theta — Time decay; rate at which option loses value as expiration nears.
- Vega — Change in option value when implied volatility changes; higher volatility → higher option price.
Black–Scholes
Fischer Black and Myron Scholes won the Nobel Prize in Economics for this work (1997).
The formula gives a theoretical fair value for a European call option.
It assumes the underlying price follows a log-normal process and that the option can be continuously hedged with the underlying.
The call value depends on underlying price, strike, time to expiry, risk-free rate, and volatility.
Volatility is central: higher volatility means a higher option premium.