Forwards, Futures, Swaps and Options

I would like to continue with my last post about Derivatives and go into a little further detail about the main types of Derivatives and also explain how they relate to Risk Management.

A forward contract is a contractual agreement between two different parties. One of these parties agrees to buy a certain asset at a predetermined price and the other party agrees to deliver this asset at the same predetermined price. Both parties are required to honor this contract and there are no exceptions to this. Terms of the contract can be personalized since it is negotiated directly between two parties, however there is also a higher risk that one of the firms may default on their payments. I found a good example on Global Financial Management where a wheat farmer uses a forward contract to guarantee that he can sell 5000 bushels of wheat in 5 months time at 550 cents per bushel. This farmer is using proper risk management techniques from the start to guarantee that in the case of the market price for wheat drops dramatically for any reason, he will not be affected by it. This can however not work out since the farmer might have a terrible crop this season, and he will not be able to produce 5000 bushels of wheat to the buyer, thus defaulting on his contract.

A future contract is essentially the same as a forward contract, except it is exchanged in a formal, regulated exchange instead of directly between two parties. There are a few differences between the two, such as that future contracts guarantee against default, they are standardized and they are settled on a daily basis.

A swap contract is once again an agreement between two parties that to swap payments on regular future dates. Swaps are over the counter (OTC) derivatives that are just like forward contracts that have a risk that one side could default on their commitments. Swaps are generally used to hedge against risks created by volatile interest rates, currency exchange rates, commodity prices and share prices. Usually companies that borrow from banks with variable interest rates may reduce the cost of risk by entering into a swap to fix their cost of funding.

There are two types of options; call options and put options. A call option gives the owner the right to buy a certain underlying asset at a date and a fixed date, where as a put option gives the owner the right to sell the underlying asset at a certain date and a fixed price. Options are also an OTC derivative and is usually traded between a specialized dealer or in an organized exchange market, thus a premium needs to be paid by the buyer of the option as it provides so much flexibility.