The number of financial instruments that have the characteristics of a derivative has continued to expand, and, in turn, these instruments have become increasingly complex. In spite of the diversity and/or complexity that characterizes them, most derivatives are variations of four basic types, including forwards, futures, options, and swaps. Other more complex derivative instruments are also available.
Forward Contracts. A forward contract is a contract to buy or sell a specified amount of an asset at a specified fixed price with delivery at a specified future point in time. The party that agrees to sell the asset is said to be in a short position, and the party that agrees to buy the asset is said to be in a long position. The specified fixed price in the contract is known as a forward price or forward rate. The current price or rate for the asset is known as the spot rate. The specified future point is referred to as the forward date. Forward contracts are not formally regulated on an organized exchange, and the parties are exposed to a risk that default of the contract could occur. However, the lack of formal regulation means that such contracts can be customized in response to specialized needs regarding notional amounts and forward dates.
Forward Contracts. A forward contract is a contract to buy or sell a specified amount of an asset at a specified fixed price with delivery at a specified future point in time. The party that agrees to sell the asset is said to be in a short position, and the party that agrees to buy the asset is said to be in a long position. The specified fixed price in the contract is known as a forward price or forward rate. The current price or rate for the asset is known as the spot rate. The specified future point is referred to as the forward date. Forward contracts are not formally regulated on an organized exchange, and the parties are exposed to a risk that default of the contract could occur. However, the lack of formal regulation means that such contracts can be customized in response to specialized needs regarding notional amounts and forward dates.
The value of a forward contract is zero at inception and typically does not require an initial cash outlay. However, over time, movement in the price or rate of the underlying results in a change in value of the forward contract. The total change in the value of a forward contract is measured as the difference between the forward rate and the spot rate “at the forward date.”
Futures Contracts. A futures contract is exactly like a forward contract in that it too provides for the receipt or payment of a specified amount of an asset at a specified price with delivery at a specified future point in time.
Option Contracts. An option represents a right, rather than an obligation, to either buy or sell some quantity of a particular underlying. Common examples include options to buy or sell stocks, a stock index, an interest rate, foreign currency, oil, metals, and agricultural commodities. The option is valid for a specified period of time and calls for a specified buy or sell price, referred to as the strike price or exercise price. If an option allows the holder to buy an underlying, it is referred to as a call option. An option that allows the holder to sell an underlying is referred to as a put option. Options are actively traded on organized exchanges or may be negotiated on a case-by-case basis between counterparties (over-the-counter contracts). Option contracts require the holder to make an initial nonrefundable cash outlay, known as the premium, as represented by the option’s current value. The premium is paid, in part, because the writer of the option takes more risk than the holder of the option. The holder can allow the option to expire, while the writer must comply if the holder chooses to exercise it.
Swaps. A swap is a type of forward contract represented by a contractual obligation, arranged by an intermediary that requires the exchange of cash flows between two parties. Swaps are customized to meet the needs of the specific parties and are not traded on regulated exchanges. Most often swaps are used to hedge against unfavorable outcomes. However, it is important to understand the basic format of a swap. Common examples include foreign currency swaps and interest rate swaps.