Derivatives meaning : Forward, Futures, Option & Swap

Options and swap agreements

Get a free demo Derivatives Derivatives are securities whose value is determined by an underlying asset on which it is based. Therefore the underlying asset determines the price and if the price of the asset changes, the derivative changes along with it.

Derivatives

A few examples of derivatives are futures, forwards, options and swaps. The purpose of these securities is to give producers and manufacturers the possibility to hedge risks. By using derivatives both parties agree on a sale at a specified price at a later date. In each derivative certain aspects are documented such as the relation between the derivative, type of underlying asset and the market in which they are traded.

It is essential to understand the strengths and weaknesses of each derivative to employ them to their fullest potential. Futures Futures are exchange organized contracts which determine the size, delivery time and price of a commodity.

Futures can easily be traded because they are standardized by an exchange. Per commodity traded there are different aspects specified in a futures contract.

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First of all is the quality of a commodity. For a commodity to be traded on the exchange, it must meet the set requirements. Second is the size of a single contract. The size determines the units of a commodity that is traded per contract. Thirdly is the delivery date, which determines on which date or in which month the commodity must be delivered. Thanks to the standardization of futures commodities can easily be traded and give manufacturers access to large amounts of raw materials.

Forwards Create a paid site and make money and futures are very similar as they are contracts which give access to a commodity at a determined price and time somewhere in the future.

A forward distinguish itself from a future that it is traded between two parties directly without using an exchange. The absence of the exchange results in negotiable terms on delivery, size and price of the contract.

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In contrary to futures, forwards are usually executed on maturity because they are mostly use as insurance against adverse price movement and actual delivery of the commodity takes place. Whereas futures are widely employed by speculators who hope to gain profit by selling the contracts at a higher price and futures are therefore closed prior to maturity.

Swaps A swap is an agreement between options and swap agreements parties to exchange cash flows on a determined date or in many cases multiple dates. Typically, one party agrees to pay a fixed rate while the other party pays a floating rate. For example, when trading commodities the first party, an airline company relying of kerosene, agrees to pay a fixed price for a pre-determined quantity of this commodity.

The other party, a bankagrees to pay the sport price for the commodity. Hereby the airline company is insured of a price it will pay for its commodity.

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A rise in the price of the commodity is in this case paid by the bank. Should the price fall the difference will be paid to the bank.

Caps, floors and collars Cap and floor options can be used as an insurance against negative price movements. When two parties agree on a swap contract, both parties take a risk on the price movement of the underlying commodity. To reduce this risk they can also agree on a cap or floor option.

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This is similar to a swap, because two parties agree to exchange cash flows. The difference is the usage of a maximum or minimum price.

With a cap option, a cash flow will only occur when the spot price rises above the cap price. When the price remains under the cap price a company will buy the commodity for the sport price.

When the spot price rises above the cap price, the difference between the spot and cap price will be paid by the other party. A floor option works similar to a cap option, because the exchange of cash flows only takes place when a condition is met. The only difference is that a cash flow now only takes place when the spot price drops below the floor price. A collar option is a combination of both a cap and floor option. It sets a maximum and a minimum price. When the spot price remains between these two prices, the commodity will be bought for the current market price.

What are options and how can they be used to hedge and speculate? What are swaps and how are they used to hedge and speculate? Options are aptly named financial derivatives that give their holders the option which is to say the right, but not the obligation to purchase call or sell put an underlying asset at a predetermined strike price, on if a so-called European option or before if a so-called American option a predetermined expiration date. Options are most often written on stocks equities but can be linked to other types of assets as well. To induce investors to issue an option and thereby obligate themselves to make a disadvantageous trade, option holders must pay a premium to the option issuer based on the option type, strike price, expiration date, interest rates, and volatility of the underlying asset.

Should the spot price rise or drop outside these boundaries, an exchange of cash flows will occur. Swaptions A swaption is a combination of a regular swap and an option.

It gives a holder the right to enter a swap with another party at a given time in the future. Parties usually agree on a swaption when there are uncertainties about the price movements in the future.

Just like with options, the swaption will only be executed if the price is more favorable then the spot price. If the sport price upon the maturity date is more favorable, the swaption options and swap agreements expire.

In this situation a company will agree on a new swap, based on the current market prices. Options Options are a form of derivatives, which gives holders the right, but not the obligation to buy or sell an underlying asset at a pre-determined price, somewhere in the future.

To determine whether it is profitable to exercise an option, the current market price spot price and the price in the option strike price need to be compared. By comparing both prices, a choice can be made to either exercise the option or let it expire. When exercising an option there are three positions on which the holder can find themselves. The first is in the money ITMwhere the strike price is more favorable than the spot price and thus it will be advantageous to exercise the option.

Derivatives meaning – Forward, Futures, Option & Swap Explained

The second is at the money ATM in which the strike and spot price are equal and so no advantage can be gained. The third is out the money OTMwhere the strike price is higher than the spot price.

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In this case it is better to let the option expire and buy the commodity at the current market price. There are two ways of settling an option between two parties.

Unit: Options, swaps, futures, MBSs, CDOs, and other derivatives

The first way is to physically deliver the underlying commodity. The other way is to cash settle the option.

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In this way the difference between the spot and strike price is paid to the holder of the option upon exercising of the option. An option has a few advantages over other derivatives. The most important advantage is that an option is not binding, in the way is does not obligate one to buy a commodity. It gives you the right to buy it and so when the price of the option is higher than the current market price you can just let the option expire and buy at the spot price.

The only loss made, will be the premium which is the cost for maintaining the options and swap agreements.

The common underlying assets are stocks, bonds, commodities, currencies, interest rates, etc. It is mostly used for hedging purposes insuring against price risk.

Another advantage is the usefulness of options as a hedging tool. Options offer the tools to successfully hedge price movements with a small investment risk. Asian This is a specific type of option, which like a normal option gives a buyer the right to buy an option. The difference with other options is the price of the underlying asset. The price for which the asset can be bought is not a single price, but an average of prices over a determined period.

Advantages of Asian options are the relative low costs compared to other type of options. The costs are lower because the price fluctuation is limited due to the average of prices. Another advantage is limitation of sudden price movements near the maturity date. Due to the average of prices a sudden rise of the price will only have a small effect on the price.

European With this type of option, the holder can exercise his option on the underlying asset only on the pre-determined date.

An Introduction to Swaps

He does not have the possibility to execute the option before this date and therefore has a limited ability to take advantage of sudden price movements. American With an American option it is possible to exercise an option on any moment until the maturity date of the option. This gives options and swap agreements lot of freedom options and swap agreements the holder to get maximum profit out of the option, by exercising the option on the best possible moment. Bermudan This type of option seems looks like a combination of both European and American options.

This option cannot be exercised on any date before the maturity date, but on a number of set dates. This gives the holder a little more freedom, in comparison with an European option, to exercise the option on a favorable moment.

Ticks A tick is a way of indicating a slightest price change for a specific commodity.

Swap (finance)

A tick size can differ per commodity or futures contract. It is important to know the value of a tick, to understand what this will do to the equity of an account. Monitoring the activity of ticks for a certain commodity can help decide whether or not to enter a market for a commodity.