A derivative market is a market where derivatives are bought and sold. Derivatives are financial contracts whose value is derived from another asset. There are a total of four types of derivatives that are forwards, swaps, futures, options. The value of a derivative contract depends on an underlying asset. The underlying asset can stock commodities, currency, etc. The value of the derivative is dependent on the underlying asset.so if the price or the value or the demand of the underlying asset goes up then the value of the derivative also goes up and if the value price or demand of the underlying asset goes down then the value of the derivative also goes down. In one of our last blogs, we have covered the derivatives and derivatives market in detail. Amongst forwards futures options and swaps we have explained each and every detail about futures and options in our previous blogs. In this blog, we have mainly focused on forwards and swaps. There is a specific difference between forwards futures options and swaps. We are going to cover all these topics in detail later in this blog.
This blog covers,
1. What are forwards swaps futures options?
Forwards
Swaps
Futures
Options
2. Difference between forwards futures options and swaps
3. Conclusion
What are Forwards swaps futures options?
There are a total of four types of derivative contracts that are forwards futures options and swaps. Let’s see all of these types in detail one by one,
1. Forwards
The forward contract is an agreement to buy or sell a security or a financial instrument (Basically commodity) at the future date at a certain price which is decided at the time of entering the contract. The price of the contract decided while entering into the contract for the future date is known as the delivery price.
So basically forward contract is a contract between two persons where they agree to buy or sell a commodity or a product or an instrument and in which the price is already determined before entering into the contract. After that time period or at the given point of time the commodity will be sold at that delivery price.
Another important feature of forward contracts is that these forwards are basically between two financial institutions. They do not occur traded at the stock exchanges but are mostly traded in the over-the-counter market. This means the forward contracts are mainly bought and sold in the over-the-counter market and not in stock exchanges. Let's understand forward contracts with the help of an example.
Consider two parties one is a farmer producing sugarcane and another one is a person who is owning a factory that produces sugar. The sugar factory owner needs sugarcane for the production of sugar (Here sugar is a derivative of sugarcane). The current rate of sugarcane is Rs. 20 but sugarcanes are not ready to be harvested. The farmer thinks that the current rate of sugar cane is Rs. 20 and it may go down to Rs. 18 or 17 in the future. So, he is just worried about the price drop in the future and he doesn't want to take any risk.
On the other hand, the factory owner thinks that the price of sugarcane may rise in the future as there are limited crops and he may need to pay more money in the future in order to buy sugarcanes.
So, both the parties mutually decide to buy and sell sugarcane at Rs. 22 after three months, irrespective of any price change in the future. This is a forward contract in which the person is agreeing to sell his product at a specific price on a future date i.e. here in this case after three months. After three months if the price of sugarcane goes above Rs. 20 then the factory owner will be in a profit state and if the price goes down then the farmer will be in a profit state. So in a forward contract, two persons come with an agreement to buy or sell a commodity, currency, or security at a fixed rate and after a fixed time.
2. Swaps
While trading parties exchange their cash flows usually through the intermediary bank. A swap is an interest rate transaction where the two parties exchange their interest rate for a given period.
When two people have taken loans from two different banks i.e.one person took the loan at a fixed rate of interest and the second one took the loan at the floating rate of interest. The first person thinks that I should have taken it at a floating rate because that will be more profitable and the second person who took a loan at a floating rate of interest thinks that the fixed rate would have been better as there won't be any fluctuations. Here both parties have opposite mindsets. So, these two persons can exchange their interest rates through swaps.
Through swap, the first person who chose the fixed interest rate can now pay the interest in floating rates, and the second person who chose the floating rate of interest can pay the interest at a fixed rate. So here people are swapping their interest rate therefore this swap is known as interest rate swap. This is how swaps occur.
Through swapping, companies revise their debt conditions to take advantage of current or expected future market conditions. The amount needed to service debt can be lowered by using currency and interest rate swaps.
2. Futures
A futures contract is an agreement to buy or sell a fixed quantity of a particular commodity, currency, or security at a fixed date in the future at a fixed price. You may be thinking that it is similar to the forward contract. Yes, it is similar to the forward contract but there is a certain difference between these derivatives contracts. We have explained the Difference between forwards futures options and swaps later in this blog. To know more about futures you can read our What Are Futures Contract? blog.
3. Options
An options contract is the right to buy or sell a fixed quantity of a commodity, currency, or security at a particular price but it is different from forward and futures contracts as here the person who is in option contract is not obligated to buy or spend. He/she needs to only buy or sell if he/she receives a profit.
There are mainly two types of options that is call option and put option. A call option is an option contract that gives the holder the right to buy a particular security. The call option holder has a choice between buying and not buying. On the other hand, PUT is the option contract that gives the right but not an obligation to sell the security. In both the CALL and PUT options the option holder has the right to buy or sell respectively if he/she thinks that doing this will give a profit.
Later in this blog we have compared forwards swaps futures options. So that to get clear idea about these derivatives contracts.
We have dedicated blogs on Options trading. We advise you to read this blog for a detailed understanding of options.
Difference between forwards futures options and swaps
Future contracts are always bought and sold or traded in recognized stock exchange whereas forward contracts are traded over-the-counter.
Futures are publicly traded whereas forwards are traded privately.
A forward contract is a private and customizable contract that can be changed depending upon the mutual understanding of two parties, whereas future contracts are regulated and standardized by the stock exchange. The terms and conditions can't be changed or customized depending upon the two parties.
Forward contracts are non-standard over-the-counter contracts and therefore it is harder to find a counterparty to trade in the forward contracts, whereas it is easy to buy and sell futures contracts on the stock exchange.
In forward contracts, there is a scope of negotiation whereas future contracts are Quoted and traded on the Exchange and fixed standards.
Forward contracts exhibit high counterparty risk as there is no regulatory body involved in between, whereas future contracts have very low counterparty risk as there is a regulatory body (Stock exchange) involved in between.
Contracts size in the forward trades is decided and customized as per the requirements of both parties whereas in futures contract size is standardized and set by the stock exchange.
Another difference between forwards futures options and swaps is that in the future contract a person has the right and is obligated to buy or sell a specific asset at a given time and at a given price, whereas in options the person has right but not an obligation to buy or sell a contract.
Conclusion
This way you have understood the concept of forwards and swaps. Forwards swaps futures options all these are types of derivatives and are traded in the derivatives market. Not every derivative is traded on the stock exchange. There is a difference between forwards futures options and swaps. Each has its certain characteristics, pros and cons.
