What are Forwards, Futures, options & Swaps?

Derivatives are financial instruments that do not represent ownership rights in any physical asset but, rather, derive their value from the value of some other underlying commodity or other asset.
Derivatives are efficient and effective tools for isolating financial risk and hedging to reduce exposure to risk. Derivative is a product whose value is derived from the value of one or more basic variables, called bases or underlying asset in a contractual manner. The underlying asset can be equity, forex, or commodity like crude oil, agri-products. Derivatives allow investors to transfer risk to others who could profit from taking the risk. Because of their flexibility in dealing with price risk, derivatives have become an increasingly popular way to isolate cash earnings from price fluctuations.

The most commonly used derivative contracts are forward contracts, futures contracts, options, and swaps.

1. Forwards

A forward contract is an agreement between buyer and seller parties for delivery of a specified quality and quantity of a good at an agreed date in the future at a specific price or at a price determined by formula at the time of delivery to the location specified in the contract.

Characteristics of Forward Contract:
· Terms and conditions are negotiated
· Illiquid market
· Credit risk
· Unregulated market (not exchange-traded)

The specifications included in a forward contract are:
· Product
· Price – The price at which delivery will be made in the future
· Quantity – Any number of units as mutually agreed
· Quality – Type
· Future Delivery date
· Delivery Place – How and where delivery will be made at maturity

2. Futures

A Futures contract is an agreement between two parties to buy (long position) or sell (short position) an asset at a certain time in the future at a certain price. Future contracts are standardized exchange-traded contracts. The quantity of the underlying, quality of the underlying, the date and month of expiry and minimum price change are standardized. Like a forward contract, a futures contract obligates each party to buy or sell a specific amount of a commodity at a specified price. Unlike a forward contract, buyers and sellers of futures contracts deal with an exchange, not with each other.

3. Options

Options are derivative instruments that provide the holder with the right, but not the obligation, to, pay or receive some quantity of cash or commodity, at an agreed strike price. An option is a contract that gives the buyer of the contract the right to buy (a call or put option) or sell (a put or call option) at a specified price (the “strike price”) over a specified period of time.


Advantages of Call option:
· Protection against rising markets
· Benefit from falling markets
· Flexibility to deal at the money level or at higher level
· Flexibility in physical supply

Advantages of Put Options (Floors):
· Protection against falling market
· Benefit from rising markets
· Physical flexibility

4. Swaps

A swap can be most simply defined as an agreement between two parties to exchange, at some future point, one product, either physical or financial, for another. But, in derivative form swap is purely cash settled.