Types of Derivatives

1. Forward Contracts

Definition: A forward contract is a private and customizable agreement between two parties to buy or sell an underlying asset at a predetermined price (the forward price) on a specific future date (the settlement date). These contracts are typically traded over-the-counter (OTC), meaning they are not standardized and are negotiated directly between the parties involved.

Key Features:

Customization: Terms like the asset, quantity, price, and settlement date are negotiated and tailored to the needs of the buyer and seller.
Obligation: Both parties are obligated to fulfill the contract at the settlement date.
OTC Trading: No central exchange is involved; trades are conducted directly between parties.
Counterparty Risk: Each party faces the risk that the other might default on their obligation.
Settlement at Maturity: Gains or losses are realized only at the settlement date.

Example:

Imagine a U.S. airline company that anticipates needing to buy 1 million barrels of jet fuel in six months. To hedge against potential price increases, they enter into a forward contract with an oil producer.

Underlying Asset: Jet fuel
Quantity: 1 million barrels
Forward Price: $80 per barrel
Settlement Date: Six months from today

Scenario 1: Jet fuel price rises to $90 per barrel at settlement.

The airline company benefits. They have locked in a price of $80 per barrel and can now buy the fuel for $80 million. If they had not entered into the forward contract, they would have had to pay $90 million. They have saved $10 million.
The oil producer loses. They are obligated to sell the fuel at $80 per barrel, even though the market price is $90. They could have earned an additional $10 million in the open market.

Scenario 2: Jet fuel price falls to $70 per barrel at settlement.

The airline company incurs a loss. They are obligated to buy at $80 per barrel, even though the market price is $70. They could have saved $10 million by buying in the open market.
The oil producer benefits. They have secured a selling price of $80 per barrel, which is $10 higher than the market price.

Scenario 3: Jet fuel price is equal to the forward price

Neither party gains or loses

Use Case:

Forward contracts are commonly used by businesses to hedge against price fluctuations in commodities, currencies, or interest rates.

2. Futures Contracts

Definition: A futures contract is a standardized agreement to buy or sell a specific quantity of an underlying asset at a predetermined price (the futures price) on a specific future date (the settlement date). Unlike forwards, futures contracts are traded on organized exchanges.

Key Features:

Standardization: Contract terms (asset, quantity, quality, delivery date) are standardized by the exchange.
Exchange Trading: Futures are traded on centralized exchanges, providing liquidity and transparency.
Clearinghouse: A clearinghouse acts as the intermediary for every trade, guaranteeing performance and eliminating counterparty risk.
Margin Requirements: Both buyers and sellers must deposit initial margin (collateral) and maintain a certain level of margin (maintenance margin) to cover potential losses.
Marking-to-Market: Futures contracts are marked-to-market daily, meaning that gains and losses are calculated and settled at the end of each trading day. This prevents the accumulation of large losses over time.

Example:

A wheat farmer wants to lock in a price for their upcoming harvest. They decide to sell wheat futures contracts on the Chicago Mercantile Exchange (CME).

Underlying Asset: Wheat (standardized quality and quantity specified by the CME)
Contract Size: 5,000 bushels (standard CME contract size)
Futures Price: $7.50 per bushel
Settlement Month: September

Let's say the farmer sells 10 contracts (representing 50,000 bushels).

Daily Marking-to-Market:

Day 1: The futures price closes at $7.55 per bushel. The farmer has a loss of $0.05 per bushel, or $2,500 (50,000 bushels * $0.05). This amount is deducted from their margin account.
Day 2: The futures price closes at $7.48 per bushel. The farmer has a gain of $0.07 per bushel, or $3,500. This amount is added to their margin account.

Settlement:

If the farmer holds the contracts until September and the price of wheat at that time is $7.40 per bushel, they will have made a net gain on the futures contracts ,due to the daily marking-to-market.

Use Case:

Futures contracts are used by hedgers (like the farmer) to manage price risk and by speculators who aim to profit from price movements.

3. Options

Definition: An option contract gives the buyer the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an underlying asset at a predetermined price (the strike price) on or before a specific date (the expiration date).

Key Features:

Right, Not Obligation: The option buyer has the choice to exercise the option or let it expire worthless.
Premium: The buyer pays a premium to the seller (writer) of the option for this right.
Strike Price: The predetermined price at which the underlying asset can be bought or sold.
Expiration Date: The date on or before which the option must be exercised.
Types: Call options (right to buy) and put options (right to sell).

a) Call Options

Example:

An investor believes that the stock price of Company XYZ, currently trading at $50, will rise in the next three months. They buy a call option on XYZ stock.

Underlying Asset: XYZ stock
Strike Price: $55
Expiration Date: Three months from now
Premium: $3 per share

Scenario 1: XYZ stock rises to $60 at expiration.

The investor exercises the call option, buying XYZ stock at $55 per share.
They can immediately sell the stock in the market for $60, making a profit of $5 per share.
Subtracting the premium of $3, their net profit is $2 per share.

Scenario 2: XYZ stock stays at $50 or falls below $55 at expiration.

The investor will not exercise the option, as it's not profitable to buy at $55 when the market price is lower.
The option expires worthless, and the investor's loss is limited to the premium paid ($3 per share).

Use Case:

Call options are used to speculate on rising prices or to hedge against potential losses in a short position (selling borrowed shares).

b) Put Options

Example:

An investor owns shares of Company ABC, currently trading at $70. They are concerned about a potential price decline and want to protect their investment. They buy a put option on ABC stock.

Underlying Asset: ABC stock
Strike Price: $65
Expiration Date: Two months from now
Premium: $2 per share

Scenario 1: ABC stock falls to $60 at expiration.

The investor exercises the put option, selling their ABC shares at $65 per share.
Even though the market price is $60, they can sell at the higher strike price.
Their loss is limited to $5 per share (the difference between the original price of $70 and the strike price of $65), plus the $2 premium, for a total loss of $7 per share. Without the put option, their loss would have been $10 per share.

Scenario 2: ABC stock stays at $70 or rises above $65 at expiration.

The investor will not exercise the put option.
The option expires worthless, and the investor's loss is limited to the premium paid ($2 per share).

Use Case:

Put options are used to speculate on falling prices or to hedge against potential losses in a long position (owning shares).

4. Swaps

Definition: A swap is an agreement between two parties to exchange a series of cash flows over a specified period. The cash flows are typically based on different financial variables, such as interest rates or currencies.

Key Features:

Exchange of Cash Flows: Parties agree to make periodic payments to each other based on a predetermined formula.
Customization: Swaps are OTC instruments and can be tailored to meet specific needs.
Counterparty Risk: Each party faces the risk that the other may default.
Long-Term Agreements: Swaps typically have longer maturities than futures or forwards.

a) Interest Rate Swaps

Example:

Company A has issued a floating-rate bond with an interest rate of LIBOR + 1%. They are concerned about rising interest rates.
Company B has issued a fixed-rate bond with an interest rate of 5%. They believe interest rates might fall and would prefer a floating-rate exposure.

They enter into an interest rate swap:

Notional Principal: $10 million (this amount is not exchanged, it's used to calculate the interest payments)
Company A (Fixed-Rate Payer): Agrees to pay Company B a fixed interest rate of 4.5% per year.
Company B (Floating-Rate Payer): Agrees to pay Company A a floating interest rate of LIBOR + 0.5% per year.

Result:

Company A effectively converts its floating-rate debt to a fixed rate. They pay LIBOR + 1% on their bond and receive LIBOR + 0.5% from the swap, resulting in a net payment of 0.5%. They then pay 4.5% fixed on the swap, leading to a total fixed cost of 5%.
Company B effectively converts its fixed-rate debt to a floating rate. They pay 5% on their bond and receive 4.5% from the swap, resulting in a net payment of 0.5%. They then pay LIBOR + 0.5% on the swap, leading to a total floating cost of LIBOR + 1%.

Use Case:

Interest rate swaps are used to manage interest rate risk or to change the nature of debt obligations (from fixed to floating or vice-versa).

b) Currency Swaps

Example:

U.S. Company X needs to borrow Euros to fund a project in Europe but has better access to U.S. dollar financing.
European Company Y needs to borrow U.S. dollars but has better access to Euro financing.

They enter into a currency swap:

Initial Exchange: Company X borrows 10 million and lends it to Company Y. Company Y borrows €8 million and lends it to Company X, assuming an exchange rate of 1.25/€.
Periodic Interest Payments: Company X pays Euro interest to Company Y based on the €8 million, and Company Y pays U.S. dollar interest to Company X based on the $10 million.
Final Exchange: At maturity, Company X returns the €8 million to Company Y, and Company Y returns the $10 million to Company X.

Result:

Company X effectively borrows Euros at a potentially more favorable rate than they could have obtained directly.
Company Y effectively borrows U.S. dollars at a potentially more favorable rate.

Use Case:

Currency swaps are used to manage exchange rate risk or to access financing in foreign currencies.