There are many different types of financial derivatives, but most tend to fall within one of four general categories.
In this type of derivatives contract, a customized deal is made between two parties to buy or sell a particular quantity of an asset at an agreed-upon price, with delivery of the asset taking place at a specified future date. Because of its non-standardized nature—each forward contract is tailor-made to suit the requirements of the parties in question, and can be customized to any amount, commodity, and delivery date—forward contracts are best suited to hedging, though they can be used for speculation as well. Settlements for forward contracts can take place on a cash or delivery basis. Forward contracts are known as over-the-counter (OTC) instruments because they are not traded on a centralized exchange. This makes it easier to customize terms, but also increases the potential degree of default risk.
Example: Six months from now, a farmer will have 1 million bushels of soybeans to sell, but the farmer is concerned that during that time, the price of soybeans will decline. The farmer therefore enters into a forward contract with a financial institution; under the terms of the contract, the farmer will sell 1 million bushels of soybeans to the institution in six months’ time at the specified price of $4.50 per bushel. Settlement will be on a cash basis. When the six months are up, there are three possibilities for the conclusion of the contract. The spot price (the price, for a specified time and place, at which a particular security can be bought or sold) of soybeans might be exactly $4.50, in which case neither the farmer nor the financial institution owe each other any money. If the spot price is higher than the contract price, the farmer owes the institution the difference between the two rates; if the spot price is lower than the contract price, the institution pays the farmer the difference.
Futures contracts are essentially forward agreements with one key difference: futures contracts are not traded over-the-counter, but are standardized agreements that are traded exclusively on organized exchanges. The terms and conditions of a futures contract are settled through an established clearinghouse, and futures trading is carefully regulated.
Example: On January 1, 2016, A owns 1,000 shares of stock X, valued at $100 per share. Predicting a decline in the value of the shares, A enters into a futures contract with B, a speculator predicting that the price of stock X will rise. B agrees to buy A’s shares in one year’s time at their current value. When the year passes, if the stock price has declined, A will benefit from the futures contract, as their original investment was protected. If the stock price has risen, B will benefit by earning greater value on the stock.
Similar to a futures contract, an option is an agreement between two parties that grants one party the opportunity to sell or buy a security from or to the other party at a specified future date at an agreed-upon price (the “strike price”). An option where the purchaser has the right to buy the specified security is known as a “call option;” where the purchaser has the right to sell the specified security, the option is known as a “put option.”
The difference between an option and a futures contract, however, is that an option contract offers the purchaser of the contract the right, but not the obligation, to sell or buy the security; the purchaser can make the choice independently rather than being required to buy or sell the security, no matter what the circumstances. In an options transaction, the seller of the contract, called the “option writer,” is paid an amount (the “option premium”) by the purchaser for the right to buy or sell. If the purchaser chooses not to exercise the option by the expiration date of the contract, the purchaser simply forfeits the premium paid.
In a swap contract, two parties exchange financial instruments, often cash payments, over a specified period of time based on a notional principal amount (the “notional”) agreed upon by both parties. Most often, a swap is a contract in which two parties agree to trade loan terms, such as in an interest rate swap: the loans remain in the names of the original holders, but each party makes payments toward the other’s loan. Swaps are typically over-the-counter contracts between financial institutions or businesses; they do not trade on exchanges and are not generally engaged in by retail investors.
Although interest rate swaps, in which interest payments are the instruments exchanged, are one of the most common swap types, many others exist. They include commodity swaps, which involve the exchange of a floating commodity price, often crude oil; currency swaps, in which interest and principal payments on debt in different currencies is exchanged; debt-equity swaps, which exchange debt for equity; and total return swaps, in which an asset’s total return is exchanged for a fixed interest rate.