Question

8) Please discuss the logic and process of derivatives such as futures, options, and swaps. How are the different in their structures?

Answer 1

Derivatives

A derivative denotes a contract between two parties, with its value generally determined by an underlying asset's price. Common derivatives include futures contracts, options, forward contracts, and swaps.

The value of derivatives generally is derived from the performance of an asset, index, interest rate, commodity, or currency. For example, an equity option, which is a derivative, derives its value from the underlying stock price. In other words, the value of the equity option fluctuates as the price of the underlying stock fluctuates.

A buyer and a supplier, for example, might enter into a contract to lock in a price for a particular commodity for a set period of time. The contract provides stability for both parties. The supplier is guaranteed a revenue stream, and the buyer is guaranteed supply of the commodity in question.

However, the value of the contract can change if the market price of the commodity changes. If the market price goes up during the contract period, the derivative value goes up for the buyer because he is getting the commodity at a price lower than market value. In that case, the derivative value would go down for the supplier. The opposite would be true if the market price dropped during the time period covered by the contract.

Swaps

Swaps comprise one type of derivative, but its value isn't derived from an underlying security or asset.

The most basic type of swap is a plain vanilla interest rate swap. In this type of swap, parties agree to exchange interest payments. For example, assume Bank A agrees to make payments to Bank B based on a fixed interest rate while Bank B agrees to make payments to Bank A based on a floating interest rate.

Assume Bank A owns a $10 million investment that pays the London Interbank Offered Rate (LIBOR) plus 1 percent each month. Therefore, as LIBOR fluctuates, the payment the bank receives will fluctuate. Now assume Bank B owns a $10 million investment that pays a fixed rate of 2.5 percent each month.

Assume Bank A would rather lock in a constant payment while Bank B decides it would rather take a chance on receiving higher payments. To accomplish their goals, the banks enter into an interest rate swap agreement. In this swap, the banks simply exchange payments and the value of the swap is not derived from any underlying asset.

Both parties have interest rate risk because interest rates do not always move as expected. The holder of the fixed-rate risks the floating interest rate going higher, thereby losing interest that it otherwise would have received. The holder of the floating rate risks interest rates going lower, which results in a loss of cash flow since the fixed-rate holder still has to make streams of payments to the counterparty.

The other main risk associated with swaps is counterparty risk. This is the risk that the counterparty to a swap will default and be unable to meet its obligations under the terms of the swap agreement. If the holder of the floating rate is unable to make payments under the swap agreement, the holder of the fixed-rate has credit exposure to changes in the interest rate agreement. This is the risk the holder of the fixed-rate was seeking to avoid.