Question

Please be specific and Compare different types of derivative securities

Answer 1

Derivative securities are essentially securities that derive their value from an underline asset.

In broad terms, there exists 4 types of derivative securities:

• Forwards
• Futures
• Options
• Swaps

FORWARDS

• In a forward contract, one party agree to buy/ sell an asset (may be physical/financial) at a specific price on a specific date in the future to its counterpart that agrees to sell/buy that same asset.
• Neither of the parties are required to make any payment before the initiation of the forward contract.
• The party that agrees to buy the asset is long a forward contract known as the long and expects market to go up (thus locking in purchasing price).
• The party that agrees to sell the asset is short a forward contract known as the short and expects market to go down (thus locking in the selling price).
• An important point regarding Forwards is that they are not exchanged traded, thus the parties may face counter-party risk. It is a contract developed in the OTC (Over The Counter) market.

FUTURES

• A futures contract is similar to a forward contract as one party also agree to buy/ sell an asset (may be physical/financial) at a specific price on a specific date in the future to its counterpart that agrees to sell/buy that same asset.
• However, the differentiating point is that Futures contracts are standardised and traded on an exchange.
• The long and short positions apply in the case of futures contract too.
• As compared to Forwards, Futures contracts are actively traded, relatively more regulated and require daily cash settlement of gains and losses (as may be the case).
• The counter-party risk is also reduced due to being traded on an exchange.

OPTIONS

• An Option contract gives the owner the right (option), but not the obligation to either buy or sell an underlying asset at a given specific price. (known as the strike price)
• The option owner is that party that goes Long the Option.
• There exist 2 types of options - Call Option and Put Option.
• The matrix below summaries the 4 positions of the Call and Put Option:

• On entering into an Option contract, the option owner (long position) has to pay an option premium to the short position.

SWAPS

• A Swap is an agreement to exchange a series of payments (may be based on benchmarks) on periodic dates. These periodic dates are also known as settlement dates which are over a certain period of time.
• Both parties in a Swap agreement are not required to make payments to each other at the settlement date. Only netted payments are exchanged between the parties. (i.e., the party that makes a loss would pay to the party that gains)
• Swaps are customised instruments, but are largely unregulated due to which default risk are an important aspect.
• There are various types of Swap agreements such as a plain vanilla swap, basis swap, etc.