Some exchange-traded funds (ETFs), including commodity funds, leveraged funds, and inverse funds, rely on derivatives instead of other types of assets to track the performance of their indices. Many ETFs use a mix of derivatives and assets like stocks. (Derivatives are financial instruments whose value is derived from the price of an underlying asset.)
Futures Contracts
A futures contract is an agreement between a buyer and a seller to exchange a specific asset at a predetermined date set by the parties involved in the transaction. The contract includes a description of the asset, the price, and the delivery date.
Futures contracts are traded publicly on exchanges, and thus they are subject to strict regulation in the United States by the Commodity Futures Trading Commission. Because they are regulated, there is no risk of either party defaulting on their obligations.
Futures contracts are a very liquid type of derivative, meaning they can be easily bought and sold, and investors can generally enter and exit futures positions quickly.
Forward Contracts
A forward contract is similar to a futures contract, but it is not traded publicly on an exchange. Forward contracts are private agreements between the buyer and seller. Because forward contracts are traded privately, they are typically not subject to regulation, thus there is a risk that either party may default on the contract.
One significant advantage of forward contracts over futures contracts is that they can be customized to meet the exact needs of the buyer and the seller, while futures contracts are standardized; for example, to include the exchange of 5,000 bushels of corn specifically.
Swaps
A swap is a contract between a buyer and a seller to exchange multiple cash flows on predetermined future dates. The value of these cash flows is determined by a dynamic measure such as an interest rate, where one party receives a fixed amount on each date, and the other party receives an amount that varies according to a benchmark rate.
Options Contracts
There are two types of options: call options and put options. A call option gives the holder the right, but not the obligation, to buy a specific asset at a specified price on a specific expiration date. For example, a call option holder may be able to purchase 100 shares of XYZ Company on the expiration date at a price of $25 per share from the option seller. If the stock price rises above $25, the holder will want to exercise their call option and buy the stock. If the stock price falls to $10, the holder will not exercise their right to do so because they can buy the stock at a lower price in the open market.
A put option is the opposite of a call option. In this case, the holder of the put option has the right to sell 100 shares of XYZ at $25 per share. If the stock price drops to $10, the put option holder would exercise their option to sell the 100 shares back to the option seller for $15 more than the current value. If the stock price rises above $25, the holder will not want to sell the stock to the option seller for less than they could get in the open market, so the holder would let the option expire worthless.
These are some of the common derivatives used in exchange-traded funds. The use of derivatives allows these funds to effectively and flexibly track the performance of indices and assets. Investors should understand these derivatives and the associated risks before investing in exchange-traded funds.
Source: https://www.thebalancemoney.com/derivatives-in-etfs-1214889
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