Forwards, Options, Futures and Swaps – What’s the Difference?
Derivative financial instrument (or simply derivative) is, in fact, the contract, the cost of which varies depending on the fluctuations in price of “underlying asset” (exchange rate, interest rate, commodity price or security, etc.). Put simply, this is an agreement on the transfer of funds or assets within a reasonable time at a price determined at the time of transaction.
Initially, these transactions in most cases were concluded with the purpose of crediting and hedging. For example, a manufacturer of grain negotiated with the consumer in spring, to what extent and at what price grain will be supplied in autumn, thus obtaining product sales guarantee, as well as necessary during the period of sowing funds from the sale of the instrument. The buyer could be quite calm, because at the right time he would receive the goods, and also had the opportunity to win in the price, as by autumn grain price tags could go to growth.
Over time, however, the derivative market has got a much more speculative nature, and now we are talking not so much about the actual deliveries, but about the game on the rates of such securities. There appeared even contracts called “calculated”, which do not provide delivery of anything upon the expiry of their term.
Here are a few basic types of derivatives:
- Forward assumes the delivery of the asset to the buyer by the seller of the contract or the performance of alternative monetary obligation. Alternatively, the sides may have a mutual commitment at the forward execution time depending on what will be the value of “basic asset”.
- Futures is essentially a standardized forward contract: the number of “underlying asset” is strictly defined, and the parties agree only on price. Futures are freely traded on the stock exchanges.
- Option, unlike futures, gives a purchaser the right, but not the obligation, to buy (an option call) or sell (an option put) a certain number of “underlying asset” at a specified price. There are standardized exchange-traded options and OTC options concluded on arbitrary conditions.
- Swap involves the conclusion of the transaction on purchase/sale of the asset with the simultaneous conclusion of counter transaction on reverse sale/purchase of the same asset after a certain period on the same or different conditions. There is a number of swaps, most of them are used for risk hedging purposes.
In the global banking practice the use of credit derivatives is growing rapidly. If in the middle 90s, when they were just beginning to be applied, the derivative market was conventionally estimated at $ 40 billion, then already in 1998 – at $ 350 billion, and in 2000 – more than at $ 700 billion. Now the cost of credit derivatives exceeded, according to different estimates, $ 5 trillion.
Such rapid growth was due primarily to investment banks. The first credit derivatives were used in the risk strategy of American Bankers Trust, which concluded in 1992 the first deal with default swaps. The same bank in cooperation with Credit Suisse Financial Products began to implement credit notes in 1993.
Derivative financial instruments are the products of the activity of financial intermediaries that, basing on the needs of the market subjects and various existing financial mechanisms, create a tool with more acceptable characteristics, that are able to meet the economic needs of consumers, which market assets serving as the derivative basis do not have. Such characteristics may relate to terms and conditions of payment of financial obligations, taxation issues, liquidity improvement and investment attractiveness, lower transaction and agency costs as well as other significant conditions.
Main Functions of Securities Market
The essence of the international market of derivative financial instruments is disclosed more fully in the functions it performs.
Determining total function of the international derivatives market is the further development and improvement of the use of capital in its fictitious form, not operating directly in the production process and not playing the role of a loan capital (credit). Derivative financial instruments create fictitious capital, and provide its movement.
Thus, derivatives are fictitious capital in its purest form. In other words, the emergence of derivative financial instruments is the result of active innovation activities related to the development and expansion of the use of capital in its fictitious form.
An application function of international derivatives market has become the financial risk management. Protection from the risks of basic financial assets, being fundamental for the establishment and functioning of derivatives, dialectically led to risk increasing when they are applied. Accordingly, the constant attention of the participants is aimed at controlling and limiting new risks related to the functioning of derivatives themselves, including in credit, investment, foreign exchange and stock operations.
To perform this function of the international derivatives markets states develop open standards of activity, participants of the international financial market create technical systems of regular risk assessment (solvency, liquidity, foreign exchange rates, partner and so on.). Analytical and historical together with analytical and situational schemes of identifying and assessing the factors determining the risks serve the same purpose.
Another application feature of the international derivatives market is implementation of arbitration and speculation through them.
Interesting kind of swap is a credit default swap which is an agreement under which the buyer makes a one-time or regular contribution to the seller of the swap, who takes the responsibility to repay the loan issued by the buyer to a third party, in case of insolvency of the borrower. In case of default of irresponsible “third party”, the owner of the swap receives from its issuer the indemnification of losses. Such is the “insurance policy”, which can be sold.
Options and forwards for the credit spread are derivatives based on yield of the underlying asset and its equivalent at maturity. As an equivalent, government bonds are most often used, and the value of the forward or the option is determined by the difference in the yield on these assets.
That’s all for now. Got any questions? Just ask the expert!