It is important to distinguish the futures market (also called the derivatives market) from the stock market and from ordinary commodity trading markets.
Because the futures market is organized and operates in a way similar to the stock market, but with different types of underlying goods, it is often referred to as the securities derivatives market.
Today, the financial market offers several types of derivatives: futures, options, interest rate swaps, and more, with new derivative instruments emerging over time.
What Are Financial Derivatives?
Table of Contents
Financial derivatives are financial instruments whose value depends on the price of one or more underlying assets.
-
In the stock market, traders buy and sell equities or bonds to become owners or creditors of capital.
-
In the derivatives market, contracts such as futures and options represent transactions in products that are a step removed from the underlying asset.
Participants in the derivatives market appear to be trading certain goods, but in many cases they do not actually need to own or physically exchange the underlying commodities or money. Instead, they “borrow” the value of these underlying assets to hedge risks or to profit from price fluctuations.
For example, investors might create futures contracts for agricultural products without ever intending to physically deliver or receive those products. Most of them neither have nor need the actual goods. Even those who require the goods may choose not to handle physical delivery, instead using futures contracts for risk hedging.
Similarly, for higher-level instruments such as foreign currencies, interest rates, or stock indices, investors are not trading the actual assets. Instead, they create futures contracts on those assets to profit from price differences or to hedge against risk.
The Nature of the Futures Market
The core activity in the futures market is investing money in the price movements of an underlying commodity to earn profits. But unlike ordinary commodity contracts, these transactions are institutionalized on exchanges, where the primary purpose is not the physical exchange of goods, but rather the circulation of capital based on price movements of the underlying commodities.
For this reason, the futures market is a financial market in its own right.
It is essential to understand this clearly to avoid the misconception that the futures market is just a subset of the stock market or that only foreign exchange or other financial instruments count as financial futures.
Key Clarifications
-
First, the futures market is not dependent on the stock market.
-
Futures trading is conducted through exchanges similar to those in the stock market.
-
In some countries, stock exchanges and futures exchanges may be merged, allowing futures contracts to be listed on a stock exchange. However, this does not mean the futures market depends on the stock market.
-
-
The futures market is organized much like the stock market: investors place buy and sell orders through the exchange, and prices are determined through open outcry or electronic auction.
Differences from the Stock Market
-
Separate Legal Framework: Most countries have separate laws and regulatory bodies for futures markets. These agencies operate independently and in parallel with stock market regulators.
-
Variety of Commodities: Futures markets trade a much wider range of products—not limited to stocks and bonds. These include agricultural products, energy commodities, financial instruments, and more.
-
Exclusive Trading of Futures Contracts: Futures contracts are traded only within the futures market. They cannot be traded on the stock market or exchanged freely on the open market. Participants must trade under the close supervision of regulatory authorities through margin accounts.
-
Second, the futures market is not the same as a traditional physical commodity market.
-
If parties simply want to exchange goods and money, they can create a civil or commercial contract with a deferred delivery clause.
-
The futures market, however, rarely involves actual delivery of goods. Instead, it is primarily a marketplace for managing price risk.
-
In this market, hedgers (those who need or produce the goods) transfer price risk to speculators (those willing to assume the risk to seek profit). The participation of speculators in transferring risk and capital flows transforms the futures market into a true financial market.
Conclusion
The futures market is a financial derivatives market, organized in the model of the stock exchange but trading a wide variety of regulated commodities and financial instruments. When parties commit to deliver and receive goods, they formalize this in a futures contract, which serves as the foundation of transactions within the futures market.