Derivatives Market: Futures, Options and Swaps

Futures

Forward/futures is a particular type of contract where one party is obligated to purchase an underlying asset for a fixed price at a later date in the future, whereas another party is obligated to sell this asset at that fixed price Let’s take into account a classical example of a currency forward. A US exporter is about to receive million in payments for the goods they sold (payment duration – 6 months). Current EUR/USD exchange rate – but if it drops 10% the exporter would lose million within the 6 month period. However, by entering a forward contract (short position) the exporter has an opportunity to lock in the current currency exchange rate. When the rate falls  (assuming euro depreciation)  the exporter will get a million at the end of the contract lifespan. This also may be considered a hedging as taking this SELL position will help reduce risk of losing a decent amount out of a million. Since there is no physical cash changing hands, once the exporter enters a forward contract, the market value should equal to 0 at the initial step, otherwise the exporter would receive some value for nothing, or an arbitrage opportunity may occur.

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Options

Options can be written on any underlying asset the investor is about to buy or sell. A call option is a financial derivative that gives a right, but not an obligation, to its holder to purchase a certain number of assets at a given price in the future. A put option is the opposite derivative where a holder has a right to sell a certain number of assets at a given price in the future.  The given price is called a strike price. When a holder seizes an opportunity of this right he will exercise an option.

An option premium is the price, which is paid for this option in the very first day of the contract initiation (cash changes hands).

Options can serve as an excellent source of leverage and minimize risk, too. Let’s have a look at the following example. Suppose an investor believes that the stock price of $40 is too low for a particular corporation and might be heading up. The premium on a call option that gives the right to purchase a stock for $40 is $5. Maturity period – 6 months. The investor is willing to acquire call options on shares for $500. He will be in-the-money if a stock price will grow within the 6 month period.  However, if the investor did not use call options but invested in 100 stocks he would need additional $3500 in the form of loan. At the maturity date the loan must be repaid, thus the investor would lose a portion of the profits. For 100 stocks the investor needs $4000 that he might lose if a stock value will drop significantly (plus interest if it reaches 0). With the call option, however, what he can lose is just $500, which apparently is a less risky investment.

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Swaps

A swap is fixed-term contract to exchange cash flows within a certain period of time.  The principal amount of these cash flows is called notional.

Let us consider an example with a floating consumer credit of $20,000 and yearly payments of $1000. If the interest rate doubles, the payment will increase, too. You as a creditor might have option of eliminating or hedging the risk by re-financing with a fixed consumer rate but that will increase the transaction costs dramatically. Swap contracts allow you to renegotiate the consumer loan and thus minimize the risk of the rate rise. With the swap contract you could make an agreement with counter party – let’s say a financial institution – and pay a fixed rate installment bound to $20,000. In return, you will be receiving a floating rate installment applied to the same $20,000. Under swap contract terms you can use these floating payments to redeem your consumer credit. The only costs you will be having now are those associated with the bank fixed rate payments as if you had a fixed consumer loan. In fact, a double rate increase will NO longer affect your own private funds and put at risk a loan failure to be paid off.

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