I begin with a description of the simplest types of derivatives: forwards, futures, options and swaps. To illustrate a forward contract, consider the following example (unless otherwise stated, all prices are in rupees per gram). Jewelry manufacturer Goldbuyer agrees to buy gold at Rs. 600 (the forward or delivery price) three months from now (the delivery date) from gold mining concern Goldseller. This is an example of a forward contract. No money changes hands between Goldbuyer and Goldseller at the time the forward contract is created. Rather, Goldbuyer’s payoff depends on the spot price at the time of delivery. Suppose that the spot price reaches Rs. 610 at the delivery date. Then Goldbuyer gains Rs. 10 on his forward position (i.e. the difference between the spot and forward prices) by taking delivery of the gold at Rs. 600.
A futures contract is similar to a forward contract, with some exceptions. Futures contracts are traded on exchange markets, whereas forward contracts typically trade on OTC (over-the-counter) markets. Also, futures contracts are settled daily (marked-to-market), whereas forwards are settled only at expiration.
Returning to the example above, suppose that Goldbuyer believes that there is some chance for the spot price to fall below Rs. 600, so that he loses on his forward position. To limit his loss, Goldbuyer could purchase a call option for Rs. 5 (the option price or premium) at a strike or exercise price of Rs. 600 with an expiration date three months from now. The call option gives Goldbuyer the right (but not the obligation) to buy gold at the strike price on the expiration date.15 Then, if the spot price indeed declines, he could choose not to exercise the option, and his loss would be limited to the purchase price of Rs. 5. Alternatively, Goldbuyer may anticipate that the spot gold price is very likely to decline, and attempt to profit from such an eventuality by buying a put option, giving him the right to sell gold at the strike price on the expiration date.
Swaps are derivatives involving exchange of cash flows over time, typically between two parties. One party makes a payment to the other depending upon whether a price is above or below a reference price specified in the swap contract.
A futures contract is similar to a forward contract, with some exceptions. Futures contracts are traded on exchange markets, whereas forward contracts typically trade on OTC (over-the-counter) markets. Also, futures contracts are settled daily (marked-to-market), whereas forwards are settled only at expiration.
Returning to the example above, suppose that Goldbuyer believes that there is some chance for the spot price to fall below Rs. 600, so that he loses on his forward position. To limit his loss, Goldbuyer could purchase a call option for Rs. 5 (the option price or premium) at a strike or exercise price of Rs. 600 with an expiration date three months from now. The call option gives Goldbuyer the right (but not the obligation) to buy gold at the strike price on the expiration date.15 Then, if the spot price indeed declines, he could choose not to exercise the option, and his loss would be limited to the purchase price of Rs. 5. Alternatively, Goldbuyer may anticipate that the spot gold price is very likely to decline, and attempt to profit from such an eventuality by buying a put option, giving him the right to sell gold at the strike price on the expiration date.
Swaps are derivatives involving exchange of cash flows over time, typically between two parties. One party makes a payment to the other depending upon whether a price is above or below a reference price specified in the swap contract.
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