Forward contracts are derivative contracts where two parties agree to exchange an asset at an agreed upon fixed price at a later date. These instruments are traded over-the-counter.
The two parties also agree on many other things apart from the price when the contract is signed. The other things include the mode of settlement (cash or delivery), contract size, specific identity of the underlying asset, etc.
Let's take an example to understand the forward contracts. Suppose two traders A and B agree to take a position in a forward contract for gold at a price of $1,100 per ounce. Trader A agrees to buy 35 ounces of gold (the quantity can be customized) at a price of $1,100 per ounce from Trader B after two months. The contract can be cash settled or deliverable. The cash-settled contracts are also called non-deliverable forwards or contracts for differences. Let's assume that the spot price of gold at the contract expiry date is $1,120 per ounce. Now, the long party in the forward contract has a profit of $20 per ounce (=$1,120 - $1,100) because the price has increased and the long party can buy the contract at $1,100 per ounce. If the contract is cash settled, then the short party in the forward contract will pay the long party a total sum of $700 (=35*$20). If the contract is deliverable, then the short party will deliver 35 ounces of gold to the long party at an agreed upon location and will receive $1,100 per ounce from the long party. The quality of gold is also pre-decided at the contract initiation i.e. whether it would be 22 karat gold or 24 karat gold etc. The party that will bear the transportation charges in the case of deliverable settlement is also decided at the contract initiation.
The payoff is symmetric and linear i.e. if the spot price at the contract expiry is greater than the forward price then the long party will gain the difference between the two, and it will also lose the similar amount if the spot price is lower than the forward price.
Futures contracts are standardized versions of forward contracts. These contracts are similar to the forward contracts in payoff and how they are structured. They differ than the forward contracts in liquidity and protection against credit loss. The clearinghouse is the counterparty to every long and short party in these contracts, and it requires some money in the margin account for the performance guarantee to make sure that there is no credit loss.
The futures contract is standardized, i.e. the expiry date is not customized, and the expiry generally occurs on the last Thursday of every month. The contract size is also standardized. For example, the lot size for gold can be fixed at 20 ounces per lot. A trader can take a position in the multiple of lot size only i.e. 20 ounces, 40 ounces, 60 ounces and so on. The trader cannot take a position in 35 ounces as the contract size is not customized like forward contracts. Futures contracts are generally more liquid than their forward counterparts.
The other party to the trade is the clearinghouse in the futures contract, and the clearinghouse requires an initial margin amount in the margin account. Suppose a trader takes a position in a futures contract for one lot of gold (20 ounces of gold) at a price of $1,100 per ounce. The contract worth is $22,000 (=20*$1,100). Suppose the initial margin is 25 percent. Then the clearinghouse would require 25 percent of the contract worth as margin, i.e. $5,500. The initial margin is different for different assets and primarily depends on the volatility of the asset. The higher is the volatility of the asset; the higher will be the margin requirement. There will be a maintenance margin as well that would be lesser than the initial margin amount. If the amount in the margin account falls below the maintenance margin, then the trader receives a margin call and has to bring back the money in the margin account to the initial margin levels. Suppose the maintenance margin is 15 percent, i.e. $3,300 (=0.15*$22,000). If the margin amount falls below $3,300, then it needs to be brought back to $5,500 by depositing the additional margin amount. The margin account falls in value when a security falls in value for a long party and when a security increases in value for a short investor. These contracts are marked to market daily i.e. the margin accounts are changed daily depending on the price movement.
Some futures contracts have a provision limiting the price changes. These are called price limits. There are upper bands and lower bands. If the upper band and the lower band are set at 5 percent each, then there will be limit up if the price rises by 5 percent on any given day and the trading stops. The trading can only occur at a price below the limit-up price. Similarly, if the price falls by 5 percent, then there will be limit down and the trading will again halt and will resume only if the trading is done above the limit-down price. When the market hits these limits, and the trading is halted then it is called locked limit.
The number of outstanding contracts is called open interest. Each contract counted in the open interest has a long party and a corresponding short party. If someone opens a new position in the contract, then the open interest increases, and it decreases if some party offsets its old position. The futures price converges to the spot price at expiration.
Futures contracts are highly regulated and thus are more transparent as compared to forward contracts. Forward contracts offer more privacy and fewer regulatory issues. That is an advantage of forward contract over the futures contract as transparency is not always desirable to the traders. The forward contracts are customizable and thus offer more flexibility. On the other hand, the futures contracts provide generally higher liquidity and credit guarantee.
Swaps are also a type of forward commitment. Like every other derivative contract, it also requires two parties for a trade to occur. The two parties here agree to exchange a series of cash flows over a certain period. It is similar to a forward contract as the parties exchange the cash flows at the expiration. The only difference is that we have more than one settlement dates in swaps and the cash flows are exchanged more than once. So, it can be said as a series of forward contracts. It is also an over-the-counter derivative contract just like a forward contract.
Let's understand it with a simple example of a plain vanilla interest rate swap. Trader A thinks that the interest rate will come down in the future and the trader B thinks that the opposite. So, they enter into a fixed-to-floating interest rate swap. Trader A will pay the trader B a fixed rate and Trader B will pay the trader A the floating rate. So, if the interest rate rises then Trader A will gain as he is receiving the floating rate and the opposite will happen in the case of fall in the interest rates.
The notional principal will be fixed at the initiation of the contract and is not exchanged for the interest rate swaps. The notional principal is only exchanged for the currency swaps. The fixed rate cash flows and floating rate cash flows are dependent on the notional principal.
The credit risk is present in the swaps as the party in the loss can default on the payments. Netting can decrease the credit risk. Netting is a process by which the parties pays only the profit/loss to the other party and not the entire interest amount. Suppose if two parties enter into a fixed-to-floating interest rate swap at a fixed rate of 6 percent and payments are made quarterly. The floating rate is the 90-day LIBOR for the swap. If the 90-day LIBOR at the beginning of any period is 7 percent and the notional principal of the swap is $1 million, then the fixed rate payer should pay $15,000 (=0.06*90/360*1,000,000), and the floating rate payer should pay $17,500 (=0.07*90/360*1,000,000). But in the case of netting, the floating rate payer will make a payment of $2,500 (=17,500-15,000) to the fixed rate payer.
Options are different than forwards, futures, and swaps. These contracts are contingent claims i.e. the payoff depends on the certain event. An option is a derivative contract in which the option buyer pays a premium to the option seller to receive the right to buy or sell an asset at a particular price either on a specific expiration date or at any time before the expiration date.
If the option can be exercised only at the expiry, then it is called referred to as a European-style option, and if the option can be exercised any time before the expiration date and on the expiration date, then it is referred to as an American-style option. Try to remember it like E- Expiry - European and A- Anytime - American. The American and European terminologies have nothing to do with the place where the options are traded. Both American and European options are traded in Europe and America.
There are mainly two kinds of options referred to as call option and put option. A call option gives the option buyer a right to buy the underlying asset at a specified exercise price. A put option gives the option buyer a right to sell the underlying asset at a specified exercise price.
Let us try to understand the options in detail by taking an example of a call option. Suppose the stock price of Apple, Inc. is trading at $110 per share. The current trading price of the stock is known as spot price. In the market, there will be different option contracts with different exercise prices. The exercise price could be $100, $105, $110, $115, $120, and so on. You can buy the call option for any exercise price. By buying the call option, you will get the right to buy the stock price at the exercise price at or before the expiration date assuming that the option is an American option. Now, you would think that it is always better to buy a call option with a lower strike price so that you have a better chance of a positive payoff. If you buy the option for a strike price of $100, then you have a right to buy the stock at $100. It is certainly better than the option with the strike price of $120. Isn't it? Well, there is nothing further from the truth. It is true that your option is more likely to provide a positive payoff on exercising with a lower strike price, but the lower strike price call option comes with a cost i.e. option premium. The option premium will be much higher for the strike price $100 as compared to the option premium of the option with the strike price of $120. You get what you pay for the option. It is like an insurance contract for a vehicle. You can get a cover for all the things like theft, fire, accident, etc. or you can get a cover only for the accident. Obviously, when you get a cover for everything, it would cost you more. If the spot price is greater than the exercise price, then the call option is said to be in-the-money. If the spot price is equal to the exercise price, then the option is said to be at-the-money. If the spot price is lesser than the exercise price, then the call option is said to be out-of-money. It will be the exact opposite for the put option except for the at-the-money put option which has the same definition as the at-the-money call option.
It is very easy to find out the moneyness of an option. If you exercise the option right now and you have a positive payoff, then it is said to be in-the-money. For zero payoff, the option is said to be at-the-money. For out-of-money option, the payoff will be negative. The premium for in-the-money option will be greater than the premium for at-the-money option which in turn will be greater than the premium for the out-of-money option.
Now you might be thinking that why should you pay a premium for out-of-money option i.e. why to pay some money as a premium for purchasing the right of buying a stock price at a higher price than the spot price. For example, buying $120 strike for Apple, Inc. whose stock is trading at a spot price of $110. Just consider the event if the stock price of Apple, Inc. rises to $140 at expiry. So, on exercising the option, you will get a payoff of $20 because you have a right to buy the stock at $120 which is trading at $140 in the market. And if you have to pay a small premium of say $0.5 for buying the out-of-money call option, then it looks like a very good trade.
The payoff of options are asymmetric i.e. if the spot price at expiry is lower than the exercise price for a call option then the option will not be exercised and the option will be worthless i.e. the option will be worthless at expiry if it is either at-the-money or out-of-money. The only option that is in-the-money at expiry will have some worth, and that will be equal to the difference between the spot price at expiry and the exercise price.
Credit derivatives are also similar to option contracts. It is an instrument where the credit protection buyer will pay some premium to the credit protection seller. In the case of default, the credit protection seller will pay the credit protection buyer the total amount of loss that occurred due to the credit risk in the underlying contract. Most of the underlying contracts in the credit derivatives are bonds. The payoff of credit derivatives is also contingent upon the credit event. The derivative contract will have a payoff only after the occurrence of some credit event. In every single case of default or credit loss, the credit protection seller pays the credit protection buyer the amount equal to the credit loss.
There are primarily four kinds of credit derivatives:
• Total return swap: The credit protection buyer offers to pay the credit protection seller the total return (interest and principal plus any change in the bond's market value) on the underlying bond. In return, the credit protection seller pays the credit protection buyer either a fixed or a floating rate of interest.
• Credit spread option: The underlying instrument is the credit spread on a bond i.e. the difference between the bond' yield and the yield on a benchmark default-free bond. This option is possible only for the traded bonds so as to get the credit spreads any time. The credit protection buyer a credit spread and pays a premium for that to the credit protection seller. The payoff depends on whether at expiry, the credit spread at expiry is greater than the exercise credit spread or not. It is basically a call option where the credit spread is the underlying.
• Credit-linked note: The credit protection buyer holds a bond that is subject to the default risk and issues its own securities. The payoff of those securities is dependent on the payoff the underlying bond. If the bond defaults, then the payoff of the credit linked notes will also be reduced accordingly.
• Credit default swap: This is the most important credit derivative and has been used the most by the traders. It is a derivative contract where the credit protection buyer makes a series of cash payments to the credit protection seller and receives a promise of compensation for credit losses resulting from the default of the underlying instrument. So, it is essentially an insurance contract. The series of cash payment is typically a percentage of the underlying asset and is referred to as credit default swap spread or CDS spread.
The credit protection buyer need not necessarily have to carry the underlying security. The parties can speculate on the credit riskiness of any third party as well. The position of the credit protection buyer is equivalent to the short position in the bond because if the bond value falls due to some credit event, then both positions will have equivalent payoffs.
The sellers of CDS can suffer huge losses in case of credit events. When a credit event occurs, then the correlation between the defaults of various bonds increases and that led to an increased risk for the credit protection sellers. The market for CDS used to be OTC markets. But after the financial crisis of 2007, some regulations have been placed on the CDS markets that call for more transparency.
Asset-backed securities are derivative contracts in which a portfolio of debt instruments is assembled (securitized) and then the securities are issued on the portfolio in the form of tranches, which have different priorities of claims based on the credit risk and prepayment risk. Few examples of these securities are collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs). These instruments are covered in detail in the fixed income module.
There can be some hybrid instruments as well that combine two or more different instruments. For example - covered call: a combination of a short call option and long stock.
The underlying instrument for the derivative contracts can be a wide variety of instruments like equity, debt, interest rates, currencies, commodities, credit, and others (weather derivatives).
Check your concepts:
(57.4) Which of the following differences between forward contracts and futures contracts is least accurate?
(a) Forward contracts offer more privacy than futures contracts
(b) Forward contracts offer more flexibility than futures contracts
(c) Forward contracts require more margin money than futures contracts as they tend to have more credit risk
(57.5) Which of the following derivative contracts have the feature of daily settlement?
(a) Futures contracts
(b) Swap contracts
(c) Both futures contract and swap contracts
(57.6) Which of the following contracts have asymmetric payoff with regard to the movement of the underlying?
(a) Swap contracts
(b) Option contracts
(c) Futures contracts
(57.7) A trader wants to sell the right to buy an underlying at a specified price. Which of the following positions will be taken by the trader?
(a) Long put option
(b) Short put option
(c) Short call option
Solutions:
(57.4) Correct Answer is C: Forward contracts offer more privacy and flexibility than futures contracts. Forward contracts do not require any margin amount whereas futures contracts require initial margin.
(57.5) Correct Answer is A: The daily settlement happens in the futures contracts and not in the swap contracts.
(57.6) Correct Answer is B: The option contracts have asymmetric payoff with respect to the underlying movement. The contingent claims have asymmetric payoffs and the forward commitments have symmetric payoffs.
(57.7) Correct Answer is C: The trade wants to sell the right to buy the underlying. Whenever the right to buy is involved, we are dealing with the call options. As the trader wants to sell the right, he should take a short position in the call option.
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