Derivative Products

1. What are Forward Contracts?

A forward contract is a kind of structured contract between 2 parties to buy or sell the given underlying assets in which settlement take place on a specified date in future at a agreed price at current date.

The forward contract price is mainly vary with the spot price, i.e. at the price on which the asset is transferred on the spot date. The main difference between the spot price and the forward price is the forward premium or forward discount which generally considered as a profit, or loss for buyer. Forward contracts are used for hedging currency risk or exchange rate risk as a means of speculation like other derivative securities.

The main features of forward contracts are:

  • They are bilateral contracts and are exposed to counter-party risk.
  • The contract price is not available in public domain generally.
  • The contract is settled by delivery of the asset on its expiry date.
  • Each contract is customized and is unique in terms of contract size, expiry date and the type & quality of asset.
  • If party decides to reverse the contract, it goes to the same counter party, which being in a monopoly situation can manipulate the price accordingly to his own conditions.

2. What are Future Contracts?

Futures are exchange-traded contracts to sell or buy financial instruments (mainly securities) or physical commodities for a future delivery at an agreed price today. Under this both parties agree to buy or sell a financial instrument in a particular future month at a price which agreed upon by the buyer and seller.

The main features of future contracts are:

  • A futures contract allows an investor to speculate on the fluctuating price of a security, commodity or financial instrument for long position or short position, by using leverage.
  • Futures are used to hedge the price movement of the underlying asset to avoid losses from unfavorable price change.

What is the difference between Forward Contracts and Futures Contracts?

1NatureTraded on organized stock exchangeOver the Counter/ Off Exchange
2Contract TermsStandardizedCustomized
3LiquidityHigh liquidLow liquid
4Margin PaymentsRequires margin paymentsNot required
5SettlementFollows daily settlementNo interim settlement i.e. only at the end of the period.
6Squaring offCan be reversed with any other trader of the Exchange.Contract can be reversed only with the same counter-party with whom it was entered into.

3.  What are Options?

Option is a kind of contract which provides the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified strike price (SP) on or before a specified date. The seller also has the corresponding obligation to complete the trade that is to sell or buy only if the buyer (owner) “exercises” the option. The buyer shall pay a certain option premium to the seller for exercising this right.

An option that gives to the owner the right to buy at a certain price is called a “call option”; an option that gives the right of the owner to sell at a certain price is called a “put option”. Both are commonly traded in market.

Option value is generally calculated into two parts:

  • The first part is “intrinsic value” defined as the difference between the Strike price & market price of underlying asset.
  • The second part is “time value”, which depends on a many factors i.e. trade volume, demand supply, price movement, market condition which affects the price upon its expiration.

4. What are Swaps?

A swap is a kind of derivative instrument in which 2 parties enter into a contract to exchange cash flows of 1st party’s financial instrument for 2nd party’s financial instrument. The benefits in question shall be dependent on the type of financial instruments involved.

For example, 2 bonds in swap, the benefits in question can be the periodic interest amount (coupon rate) payments on with such bonds. Technically, 2 counter parties agree to the exchange one’s cash flows or stream with another’s stream. These streams are called the swap’s “legs”. The swap agreement includes the dates when the cash flows shall be paid and the way it is accrued and calculated. Usually at the time when the contract is entered into, at least one of series of cash flows is decided by an uncertain variable such as a floating interest rate, foreign exchange rate, equity price, or commodity price.

The main features of swaps contracts are:

  • The cash flows are calculated over a notional principal amount of the instrument.
  • The notional amount is usually not exchanged between counter parties. Only benefit is exchanged.
  • Swaps can be in cash or collateral.
  • Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on movement in the expected direction of underlying prices.

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