1.2 Types of Derivatives

Forwards — A forward contract, which is a relatively simple derivative, is an agreement to buy or sell an asset on a future date for an agreed-upon price. It differs from a spot contract, which is an agreement to buy or sell an asset immediately. A forward contract is traded in the over-the-counter (i.e., noncentralized) market. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a specified future date for an agreed-upon price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Typically, it costs nothing to enter into a forward contract (i.e., it has a zero fair value on the date the counterparties enter into the contract).

Futures — A futures contract is similar to a forward contract in that it is an agreement between two parties to buy or sell an asset on a future date for an agreed-upon price. However, unlike forward contracts, futures contracts are normally traded on an exchange. To make trading possible, the exchange specifies certain standardized features of the contract. Since the two parties to the contract do not necessarily know each other, the exchange also provides a mechanism that gives the two parties a guarantee that the contract will be honored.

Options — An option gives the holder the right to either buy or sell the underlying asset, depending on the nature of the option, by a future date for an agreed-upon price. However, unlike parties to forwards and futures, an option holder is not obligated to buy or sell the underlying asset. In addition, whereas it typically costs nothing to enter into a forward or futures contract, there is a cost to acquiring an option (called the premium).

Options are traded both on exchanges and in the over-the-counter market. There are two types of options:

• A call option gives the holder the right to buy the underlying asset by a certain date for an agreed-upon price.
• A put option gives the holder the right to sell the underlying asset by a certain date for an agreed-upon price.

For both types of options, the greater the amount of time until maturity, the more valuable they tend to be. An option contract specifies (1) the price at which the holder can exercise the option, known as the strike price or exercise price, and (2) the date the option expires, known as the expiration date or maturity date. American options can be exercised at any time up to the expiration date, while European options can be exercised only on the expiration date. Bermudan options are a restricted form of the American option that allows for early exercise but only on specified dates during the life of the option.

Swaps — A swap is an agreement between two parties to exchange cash flows in the future. The agreement specifies the dates on which the cash flows are to be paid and the way in which they will be calculated. The most common type of swaps are interest rate swaps and currency swaps:

• In an interest rate swap, one party agrees to pay to a second party cash flows equal to the interest on a notional principal, calculated at a specified fixed rate for a predetermined period. In return, the first party receives interest at a floating rate on the same notional principal for the same period from the other party.
• In a currency swap, parties exchange principal and interest payments at a fixed or variable rate in one currency for principal and interest payments at a fixed or variable rate, respectively, in another currency. The agreement requires the principal to be specified in each of the two currencies. The principal amounts are usually exchanged at the beginning and end of the life of the swap. Usually, the principal amounts are calculated to be approximately equivalent on the basis of the spot exchange rate at the swap’s initiation.